the other reason is that not all banks participate in the eurosystem liquidity - providing operations, but prefer to cover their needs for reserves primarily in the interbank market. for example, in normal times, of the 1, 700 banks that were eligible for eurosystem monetary policy operations, less than 500 used to participate in liquidity allotments. in a eurosystem environment, the short - term inter - temporal calculus finds another anchor : the need for banks to fulfil their reserve requirements over a monthly maintenance period. in normal times, this is accomplished smoothly throughout the monthly period, again via an inter - temporal substitution of liquidity balances by each individual bank. bis central bankers ’ speeches of the short - term rates become the driving factor in the pricing of long - dated securities, and monetary policy acquires a potent handle on the economy. in august 2007, a sudden re - pricing in the us sub - prime mortgage market changed this world. the close and predictable relationship between the expected path of policy rates and market rates broke down because the liquidity premia widened and became volatile. the elevation of market premia was especially pronounced in the spread between the three - month euribor and the expected three - month path of the overnight rate ( see slide 3 ). banks recognised a substantial counterparty risk in lending to each other, given that interbank lending was generally unsecured. but, even if collateral was taken, the ability to liquidate it at a reasonable price was severely impaired in an environment of widespread fear and uncertainty. bank positions in the interbank market can be highly persistent. large diversified banks tend to be borrowers and smaller, regional banks lenders. when the financial turmoil erupted, persistent borrowers endured a sharp and sustained jump in their funding costs and many of them had no access to markets at all. when lehman brothers finally filed for bankruptcy in mid - september 2008, widespread financial panic broke out. the paralysis of transactions spread beyond the money markets, where it had been more or less confined for a year. outside the money market, dealers play a critical role guaranteeing market liquidity. but in order to be able to take positions on both sides of the market, they need to finance their securities positions via collateralised funding. for that, they need their own capital, which they can use to pay for the margins required by those who lend them securities. when confidence evaporates, margins increase and dealers ’ capital is eroded, so

the basis for monetary policy transmission ; but, at the same time, the central bank cannot fulfil its mandate to maintain price stability if the fiscal authority does not fully honour its obligation to pay back its liabilities under all circumstances. to remove the influence of market expectations about future policy rates, it is useful to focus on the term structure in terms of spreads between sovereign bond yields of a given euro area country and benchmark yields – which can be represented by the ois curve or the term structure of german bunds. bis central bankers ’ speeches how to make these apparently conflicting instances compatible? and how to overcome the deadlock? the ecb policy response : outright monetary transactions guidance to answer these questions can be derived from the maastricht treaty and the conceptual apparatus developed in the context of the economic literature on monetary vs. fiscal dominance. these insights have made clear that, from an institutional design perspective, central bank independence and a clear focus on price stability 6 are necessary but not sufficient to ensure that the central bank can provide a regime of low and stable inflation under all circumstances – in the economic jargon, ensuring “ monetary dominance ”. maintaining price stability also requires appropriate fiscal policy. to borrow from leeper ’ s terminology, 7 this means that an “ active ” monetary policy – namely a monetary policy that actively engages in the setting of its policy interest rate instrument independently and in the exclusive pursuit of its objective of price stability – must be accompanied by “ passive ” fiscal policy. a passive fiscal policy means that the fiscal authority must be ready and willing to adjust its policy stance ( revenues and primary spending ) in such a way as to stabilise its debt at any level of the interest rate that the central bank may choose. or, to put it another way, borrowing from woodford ’ s terminology, 8 fiscal policy needs to be “ ricardian ”. 9 although the treaty shows an awareness of the need for consistency between monetary and fiscal policy, in the sense described above, to ensure lasting stability, it did not foresee that fiscal policy could go off track to an extent that requires dedicated institutions and policies able to provide financial assistance, against conditionality, in order to restore sustainability and preserve financial stability in the euro area. the creation of the efsf / esm in charge of providing support to euro area member states in difficulties and enforcing appropriate conditionality has filled this gap. it provides the euro area with a means to restore “ ricardianess ”, thereby