Yves Mersch: The limits of central bank financing in resolution
Speech by Mr Yves Mersch, Member of the Executive Board of the European Central Bank, at
the Institute for Monetary and Financial Stability (IMFS) Distinguished Lecture Series, Goethe
University, Frankfurt am Main, 30 January 2018.
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1. Introduction
My talk today will focus on the provision of central bank liquidity to entities that are close to or in
resolution - a topic that has attracted much public interest.
This discussion is taking place in the broader context of the completion of Europe's banking
union. But a single European Deposit Insurance Scheme (EDIS), alongside an effective,
common backstop for bank resolution, remains one of the missing pieces.
While we are not there yet with respect to EDIS and indeed common backstops, the need
remains for banks to be able to plan ahead and obtain liquidity, even if determined as failing or
likely to fail or once the resolution process is activated.
The question is whether and to what extent this liquidity should be provided by central banks.
The ECB's position on the matter has been constant: the provision of central bank liquidity - be it
through monetary policy credit operations or emergency liquidity assistance, should not be
automatically assumed in resolution planning. Resolution measures should be financed by
contributions from shareholders and creditors of the bank, or by the State or at Union level, but
not by central banks.
This obviously does not mean that an entity otherwise in compliance with central bank
requirements for the provision of liquidity cannot access such liquidity.
2. Guiding principles and different objectives behind the provision of liquidity
Before going into the specifics, it is important to distinguish between the actorsproviding the
liquidity; the objectives for which the liquidity is provided; and the beneficiaries of the liquidity.
Starting with the actors, they can be grouped into two categories: on the one hand, the central
banks, in the performance of both Eurosystem and national tasks; and, on the other hand,
governmental entities and supranational authorities.
If we now look at the first group of actors, the central banks, they have been granted
independence from the political instruction of the government. This means that they cannot be
instructed to provide liquidity - the provision of liquidity must be their free and independent
decision. This applies regardless of whether the central bank provides liquidity in order to pursue
the objectives assigned to it by primary law or under domestic legislation to fulfil its lender of last
resort function.
Moving on to the objectives, liquidity can be provided to serve the primary objective of maintaining
price stability. This is without prejudice to supporting national central bank objectives or to
ensuring financial stability to which the European System of Central Banks (or the ESCB) only
contributes. But it can also be provided as part of other economic or fiscal policies. While the first
set of objectives are the responsibilities of Eurosystem central banks, economic and fiscal policy
objectives are firmly within the remit of governmental entities. Central banks can exercise powers
only within their mandate and therefore provide liquidity for an objective that has been assigned to
them by law.
Concerning the beneficiaries, liquidity can be provided to a solvent institution (this is a typical
central banking function and therefore of a temporary nature) or to an insolvent institution, also for
a longer period (this, by contrast, is a government task) under the scrutiny of competition
authorities.
Having said this, I will focus first on liquidity provided by central banks.
There are two main sources of overnight central bank liquidity generally available to credit
institutions. One is in the form of Eurosystem monetary policy operations. The other is in the
form of emergency liquidity assistance or "ELA". These two sources of liquidity meet different
objectives and are provided under different legal frameworks.
Our constitutional mandate requests that we at all times to pursue the Eurosystem's
price stability objective in line with a functioning open market economy. The corollary is the
provision of liquidity must ultimately serve the functioning of the real economy. Eurosystem
monetary policy has to be provided to an entity that participates in the monetary policy
transmission mechanism. Participating in monetary policy transmission means in principle
channelling liquidity to the real economy. Extending life-lines to institutions outside the monetary
policy transmission mechanism is structural or economic policy or financial stability. But if there
are financial stability considerations the central bank can only support or participate within its
mandate.
In addition, the provision of Eurosystem monetary policy liquidity must also comply with other
requirements set down by primary law, notably with the requirement that lending is based on
adequate collateral and the prohibition of monetary financing.The Eurosystem should
be adequately protected against any risks associated with its lending activity. I will come back
to this point later. And as I have said, central bank independence also plays an important role in
the sense that a central bank cannot be instructed to provide liquidity, even in a crisis. It has to
assess the situation of each entity and decide independently.
I will make a few remarks on the - an important requirement
monetary financing prohibition
flowing from the Treaty with which the provision of central bank liquidity (including in resolution)
has to comply. Any assessment of liquidity provision against the prohibition of monetary financing
requires a careful case-by-case analysis.
The ECB has repeatedly stated in its - publicly available - Convergence Reports and in its
opinions that financing by central banks, even when granted independently and at their full
discretion, of credit institutions other than in connection with their central banking tasks, in
particular the support of insolvent credit and/or other financial institutions, is incompatible with
Financing insolvent institutions is a government task -
the monetary financing prohibition.
indeed the ECB has identified criteria to distinguish between government tasks and central
banking tasks. The ECB has also repeatedly clarified that while central banks may be involved in
administering resolution measures, they National central banks could
should not finance them.
also administer resolution measures on a genuine agency basis on behalf and for the account
that is, the government or one of its entities. In this case, however, the central
of a third party,
bank would not itself provide liquidity, but simply carry out these tasks like an agent.
It is a primary law requirement that lending can only take place against "adequate collateral". On
the basis of this fundamental requirement, the Eurosystem defines the rules and conditions for
collateral to be acceptable, or "adequate", for monetary policy purposes. This framework is set
down by means of various ECB legal acts and instruments (in particular in the General
Documentation guideline). Adequate collateral for the Eurosystem's monetary policy framework
means, first, that collateral must fully protect the central bank against losses in credit operations
as these losses are in principle, shared. Consequently the Eurosystem is required, under
primary law, to act as a secured creditor. In concrete terms this is ensured through pledge or
repurchase agreements adequately secured by an asset capable of being appropriated,
transferred and/or sold at first notice. A key point here is that a standalone guarantee has never
been recognised as adequate collateral under our framework. Guarantees can only play a limited
role, namely to make up for the lesser credit quality of a given collateral provided by a financially
sound counterparty. In no circumstances would a guarantee "cure" the lack of financial
soundness of a given counterparty, or the lack of collateral or a combination of the two,
which is often the case in a resolution scenario.
If a public guarantee can prevent insolvency, it is only after having tested its value in the markets.
If a public guarantee serves to cut out the markets and replace them with central bank liquidity it
would contravene the principle of an open market economy with free competition and could be
seen as a circumvention of the monetary financing prohibition.
Indeed it is already questionable to what extent the counterparty is able to fulfil the criterion of
financial soundness. Finally, as I just mentioned, it is an important requirement in our framework
that collateral can be freely realised and sold at a market price. In the case of a mere guarantee
this is not obvious and thereby offers a standard of protection which is legally not comparable to
appropriable collateral. If all prudential and regulatory shortcomings could be replaced by a
guarantee, it would undermine the whole framework of prudential and monetary intervention and,
in the case of public guarantees, the competition principles underlying an open market economy.
This is particularly true if a guarantee in rem would be replaced by a blanket guarantee ad
personam to a bank. Why then not allow a guarantee for all the banks to maintain financial
stability. A cure all guarantee that a central bank must accept is a handover of money creation to
the Government at EU or national level. The acceptance of own used government-guaranteed
bank bonds in the past was therefore rapidly be curtailed by the Governing Council of the ECB.
Alongside "adequate collateral", the second important layer of protection against the Eurosystem
suffering potential loss is the requirement to interact only with financially sound counterparties.
Without devoting too much time to the technical details, counterparties to Eurosystem credit
operations must fulfil certain eligibility criteria. In essence, an entity must not only be a licensed
credit institution or a branch but also needs to be financially sound. Article 18.1 of the Statute of
the ESCB also allows the provision of liquidity to " credit institutions and market participants", for
example financial market infrastructures such as central counterparty clearing houses. But I will
not reflect on this particular case if not to question that a credit institution in or close to resolution
is still participating in the market if it would have the central bank as sole or predominant
counterparty. The financial soundness of a given counterparty is assessed by the Eurosystem
on an ongoing basis, notably taking into account each entity's reported capital, liquidity and
leverage ratios. The specific eligibility criteria are to be found in our framework and in particular
the General Documentation guideline.
I should add at this point that, where necessary, the ECB's Governing Council may also take
discretionary measures in individual cases. So, in some justified instances where there are
prudential concerns, it may reject certain assets as collateral or the counterparties despite their
being eligible.
Let me turn now to the second source of central bank liquidity:
emergency liquidity
assistance, or ELA.
Emergency liquidity assistance can be provided by national central banks on the basis of
namely to preserve financial
their national competences and to pursue national objectives,
stability when a solvent entity is facing temporary liquidity issues.
The provision of ELA must likewise be backed by sufficient collateral. It must also comply with
primary law requirements, such as the prohibition of monetary financing and it should not
interfere with the tasks and objectives of the ESCB (in which case the Governing Council can
object to it).
I will make only a few more comments on the provision of central bank liquidity. Central
banks can only provide liquidity in the context of pursuing their objectives and to carry out the
tasks within their mandate. In addition, with regard to the monetary financing prohibition, the ECB
has repeatedly stated that the financing of resolution measures is a government task. Does this
mean that the Eurosystem would be prevented from providing liquidity in the context of
resolution? The answer is, not necessarily, as long as the provision of liquidity complies with the
requirements of any of the two sources of central bank liquidity I just described. These
requirements are even more strict in the case of monetary policy liquidity than for emergency
liquidity assistance. For example, in the case of the asset separation tool, liquidity can be
provided to the solvent part of the bank that is participating in monetary policy transmission and
not in order to finance the separation itself. Liquidity can be provided under the generally
applicable monetary policy rules and respecting the limits set out in the Treaty and any Governing
Council decisions. Yet, whilst the provision of central bank liquidity should not be ruled
out in resolution, it should not be assumed either.
This is precisely the reason why the Single Resolution Fund was established: financing of
resolution (setting aside the case of recent national insolvency proceedings) should no longer
come from the taxpayers, but from the banks themselves. The provision of liquidity by the Single
Resolution Fund is of key importance in the euro area. But since, for the time being, this source
of liquidity is yet to be fully operationalised, the question is where should the backstop come
from? I argue that this source cannot come from the central banks, as resolution financing is a
government task.
This is nothing new, as the idea that central bank liquidity should not be assumed nor
ruled out is laid down in the Bank Recovery and Resolution Directive (BRRD) and has
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also been underlined by the ECB on a number of occasions.
Let us now turn to the second group of actors providing liquidity in resolution -
governmental entities and supranational authorities - and the liquidity provided by the
Single Resolution Fund on which I will be relatively brief.
The SRF ensures uniform practice in the financing of resolutions within the Single Resolution
Mechanism (SRM). It also ensures that the financial industry, as a whole, finances the
stabilisation of the financial system, as it pools contributions raised at national level from entities
within the Single Resolution Board's remit in each of the 19 Member States in the banking union.
SRF support may take the form of guarantees or loans if certain conditions are met and to the
extent necessary to ensure the effective application of the resolution tools, within the resolution
scheme.
But, as you may know, the SRF is not yet fully funded. It will be gradually built up during its first
eight years of existence and should reach the target level of at least 1% of the amount of covered
deposits of all credit institutions within the banking union by the end of 2023. So it does not have
sufficient funding at this stage to provide liquidity on a large scale.
On the other hand, there is the question whether the fund will be sufficient, even in the final stage,
in the event of a very big and widespread financial crisis. And if not, where would the backstop
come from? Currently the Fund also lacks a common fiscal backstop as there are still dissenting
views concerning an eventual mutualisation of recapitalisation needs resulting from so-called
"legacy assets". In this context, one of my key messages is that the monetary financing
prohibition would prevent such fiscal mutualisation through the backdoor of the Eurosystem.
Of course, there might be situations where a "funding gap" could arise. How to fill that funding
gap will have to be assessed on a case-by-case basis, also looking at the responsibilities of
governments which are the other source of financial support in resolution through State aid.
But it is not my intention to reflect on how such future situations could be dealt with; I have come
here to discuss the limits of central bank funding in resolution. In this respect, it is important to
repeat that, ultimately, resolution planning should not assume that central bank liquidity
will fill the gaps.
3. Concrete examples
Let me now give you some concrete examples. We should clearly distinguish between two types
of cases depending on where we are in the resolution process: at the time the bank is
determined as failing or likely to fail, or when it is put into resolution.
At the time the entity is determined as failing or likely to fail
As a precondition for a resolution action to be taken the entity needs to be determined as failing
or likely to fail. This is one of the three cumulative conditions for triggering resolution. The other
two are: No private funding in the market and public interest, in the sense that resolution is
necessary to achieve its objectives (art 31 BRRD and 14 SRMR).
At that stage though, it will be too early to know whether there is a reasonable prospect of an
alternative private sector solution or supervisory intervention and indeed whether resolution is in
the public interest. Nonetheless, it is inescapable that the entity's risk profile will be worsened by
the very fact of the "failing or likely to fail" determination.
Since with "failing or likely to fail" the supervisor hands over to resolution, how can it be financially
sound since the respect of prudential criteria is by definition controlled by a microprudential
authority?
In principle, such an entity could still have recourse to Eurosystem monetary policy liquidity
provided that it complies with the counterparty eligibility criteria, in particular that it is financially
sound and has sufficient eligible collateral. However, to address the uncertainty and the
associated risk in the Eurosystem's counterparty framework, our rules provide that the entity's
access to Eurosystem monetary policy credit instruments is frozen at the level prevailing at the
time it is determined as failing or likely to fail. And this decision can obviously only be revisited
through a new decision once it is assessed that all conditions for an unlimited access have been
restored.
Moreover, if necessary, the Governing Council can also impose further restrictions on the
grounds of prudence, including suspending access to monetary policy credit operations for an
entity with very low capital ratios. Such decisions would be taken on a case-by-case basis to
address the specific risk presented by the counterparty.
Now let me elaborate further. Let us assume that following the "failing or likely to fail"
determination, the entity is facing cash outflows. Since the terms of its access to Eurosystem
monetary policy credit operations will have been frozen and perhaps even further restricted, it will
not be able to meet its increased liquidity needs through this means.
What will the bank do? It is likely to seek recourse to ELA from its national central bank in order to
meet these additional liquidity needs. So if the entity is assessed as "solvent" by the competent
supervisory authority and it has sufficient clearly identified eligible collateral it will most probably
receive ELA from its national central bank.
Let me pause a moment on these two concepts. The microprudential authorities' assessment of
"solvency" under the current ELA agreement is based on a number of backward-looking
indicators, such as the reported Common Equity Tier 1, Tier 1 and total capital ratios with a
possible grace period in the case of a credible prospect of recapitalisation within a limited
timeframe. We will probably change these indicators in the future in order to take account of
forward-looking elements, in line with the evolution of supervisory practices, so as to have a
more accurate picture about the solvency of the bank and the appropriateness of continuing to
provide ELA, and in view of the fact that FOLTF means a handover to resolution authorities.
What constitutes sufficient collateral for the purposes of ELA is currently for the different national
central banks (NCBs) to define. It is, however, essential that sufficient information on such
collateral is made available to the relevant NCB and, in turn, to the Eurosystem. If there isn't
enough information, higher haircuts will need to be applied to make up for the increased risk until
the necessary details are provided.
But ultimately, the provision of emergency liquidity assistance depends on each central bank's
national framework, since ELA is carried out as a national function which national central banks
may perform unless the Governing Council finds with a 2/3 majority that it interferes with the
objectives and tasks of the ESCB.
Since the provision of ELA can interfere with implementation of the single monetary policy (as it
is a parallel source of liquidity to the single monetary policy), the Governing Council needs to be
informed of the ELA operation in a timely manner. It will assess the situation and, if an
interference with Eurosystem tasks is indeed established, object to the granting of ELA. The
specific form of an eventual objection is at the discretion of the Governing Council. The
Governing Council could, for instance, set certain limits or conditions on the provision of ELA, like
the preservation of the financial independence of the NCB.
So central bank liquidity could be rolled over within the limits of the entity's frozen access and
through ELA, but this is clearly not warranted in all scenarios for an entity determined as failing or
likely to fail.
At the time the entity is put into resolution
I've talked about central banking funding at the time the bank is determined as failing or likely to
fail. Let us now examine what can happen later on in the process.
First of all, there are some clear-cut situations where no liquidity can be provided by a central
bank, be it under the monetary policy framework or ELA. This is the case for entities put into
insolvency or liquidation proceedings.
Second, let us take the example of an entity that is put in resolution following a "failing or likely
to fail" determination. Let us assume that it is no longer contributing to monetary policy
transmission, because it no longer channels liquidity to the real economy and is in the process of
being wound down.
Wind-down entities, whose main purpose is the gradual divestment of their assets and the
cessation of their business, have been excluded from access to monetary policy credit
operations. This applies for asset management vehicles, too.
As regards their access to emergency liquidity assistance, the relevant central bank assesses
the situation of each entity according to that central bank's national framework. However, in most
cases, such entities are unlikely to obtain access to ELA if there are doubts as to their solvency,
or if this would raise monetary financing concerns.
Third, let us take the situation where the application of one of the resolution tools will lead to the
credit institution becoming financially sound again. This would happen through the sale of
business tool, the bridge institution tool, the asset separation tool, or the bail-in tool.
The use of these resolution tools will give rise to a number of individual situations which I will not
detail here. I can say, though, that in situations in which the failing counterparty continues to exist,
its restored solvency will first have to be confirmed by the competent supervisory authority before
the Governing Council will decide to "unfreeze" its access to Eurosystem monetary policy
liquidity. Such confirmation of the entity's solvency will also be needed for the provision of ELA.
The entity would need to be handed back to the relevant competent supervisory authority to
provide information on the required observation of ratios.
If the entity is a newly created counterparty, such as a bridge bank, it will first have to be licensed,
or obtain a licence, to operate as a credit institution. It will then have to be accepted as a
Eurosystem counterparty. This means it will have to fulfil all the eligibility criteria set down in our
framework, including the requirement to comply with the relevant capital, liquidity and leverage
ratios.
Therefore, if applying one of the resolution tools results in the entity's financial soundness being
restored, or if combining its business with that of an absorbing entity results in the emergence of
a financially sound entity or group, access to central bank liquidity could resume after the
Eurosystem has made its assessment. But this will depend on the elements I have just
described.
Time and planning will be of the essence. Indeed, in this stage, the flow of information will be
crucial and the competent supervisory authority will have to provide all relevant information on
whether the counterparty is fulfilling its capital requirements, so that the necessary decisions on
access can be taken.
4. Conclusion
Let me draw to a close.
As I have already indicated, liquidity provision by central banks in the event of resolution must not
be assumed ex ante, even though the possibility is not excluded provided the specific rules and
objectives of the Eurosystem are followed. The provision of central bank liquidity will be the
independent and ad hoc decision of the Eurosystem under the respective frameworks for
monetary policy and potential emergency lending not interfering with monetary policy.
Resolution financing is a government task, now complemented by the rules and procedures
applied by the Single Resolution Board and the national resolution authorities within the
framework of the SRM. Central banks provide liquidity, not solvency support. And funding gaps
that cannot be addressed by the industry or through the Single Resolution Fund should be filled,
ultimately, by Member States.
Thank you for your attention.
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Opinion CON/2012/99 on the proposal for the BRRD: "The ECB wishes to underline that this provision should not
in any way affect the competence of central banks to decide independently and at their full discretion on the
provision of central bank liquidity to solvent credit institutions, both in standard monetary policy operations as
well as emergency liquidity assistance, within the limits imposed by the monetary financing prohibition under the
Treaty".