Fire sales would weigh on profits, further deteriorating banks’ capital positions, generating in the process negative externalities and sub-optimal collective behaviour. Therefore, to be successful, significant reductions on the assets side of the banks’ balance sheet require a stabilisation of the economic and financial environment. Raising capital is also challenging in an unstable environment. Uncertainty about the pricing of the risky assets and the overall risk surrounding the valuation of banks makes it particularly difficult to attract new equity investors. Raising capital in such circumstances may not be accepted by shareholders as it may send a negative signal to the markets and lead to a drop in share prices. And, compared to 2008–2009, credible government support for banks’ capital positions was less available. This left banks with the third option, namely, to reduce lending. Banks could easily stop rolling over their loans or granting new ones. This strategy, however, while optimal from an individual bank’s perspective, would lead, if pursued collectively, to a credit crunch, with significant negative consequences on the real economy and additional strains on the banking sector. A credit crunch would have been particularly dangerous for small and medium-sized enterprises (SMEs), given their heavy reliance on bank funding. It is no exaggeration to say that SMEs form the backbone of Europe’s economy, accounting for approximately two-thirds of employment. Let me give you a few statistics: SMEs constitute about 99% of all firms in the euro area, employ 72% of the euro area’s labour force and generate around 60% of value added.

Some observers have argued that since banks are re-depositing with the ECB large amounts of liquidity, the injected liquidity is not circulating within the system and therefore the ECB’s actions will be ineffective in preventing deflationary pressures. Others, however, have warned that since these large amounts of excess reserves may remain in the system for a relatively long time, if they are not appropriately absorbed they will hamper the ECB’s ability to keep inflationary pressures in check. These fears are of course contradictory. In order to dispel them, let’s look more closely at the channels of transmission through which the excess liquidity circulates in the system. The first criticism – that large-scale use of the deposit facility demonstrates the ineffectiveness of ECB’s measures – reflects a fundamental misunderstanding of the functioning of the operational framework of the ECB. By an accounting identity, any amount of liquidity injected in excess of the liquidity needs of the banking system will be necessarily re-absorbed via the deposit facility. The increase in the deposit facility does not provide any information whatsoever about how banks use the funds borrowed from the central bank. BIS central bankers’ speeches  5  For instance, a bank which has borrowed from the ECB can use the funds to grant a mortgage to a client, who in turn uses that credit to pay construction workers, who in turn may buy a car, and so on. After each transaction, the buyer transfers the amount from his or her bank account to the seller’s bank account.