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The Black Swan in the European Money Market

In the words of Jean-Claude Trichet (January 23, 2008): “Once the Governing Council has defined the monetary policy stance necessary for maintaining price stability in the medium term, in line with its mandate as defined by the Treaty.

The ECB has the responsibility to also ensure the smooth functioning of the money market we influence. The two should not be mixed.”

“In early August, we responded to the sudden upward pressures on the overnight interest rate [i.e. EONIA, see definitions below] by lending significant amounts of liquidity through overnight fine-tuning operations. We also carried out, and later renewed, two supplementary longer-term refinancing operations in order to reduce banks’ concerns over their longer-term funding during a period when the longer-term repo and deposit markets turned illiquid.”

“These large amounts of liquidity have always been absorbed later on during the maintenance period, so that the ECB has only provided banks with the liquidity needed for the fulfilment of their reserve requirements on average over the maintenance periods. Let me also underline that we only provide such operations against solid collateral, as always.”

The result of the ECB’s commendable term liquidity injections without changing the overall money supply (i.e. by leaving the main refinancing rate constant at 4%) emerges in the Graph below. While the expected unsecured overnight lending rate banks charge each other converged back near the target 4% from the 4.3% in August, the interest rate banks charge each other for a term deposit over 3 months is back at 70bp over the usual 5-10bp over target rate. Banks are unwilling to lend to each other beyond the shortest maturities.

As emerges from the definitions below, LIBOR is the base rate for the vast majority of variable rate loans to households and corporates and for interest rate derivatives. If LIBOR stays high, troubles in the financial sector are likely to spill over into the real economy via higher borrowing costs. In addition, banks’ need to restore balance sheets may lead to lending restrictions.

Importantly, the interbank liqudity hoarding phenomenon is not specific to the ECB’s monetary policy stance: the same is observed in the U.S. and the UK, where central banks engaged in monetary policy easing at different digrees since August.

The Graph above and the title reference is taken from a new paper by John Taylor (Stanford University) and John William (Federal Reserve Bank of San Francisco). The authors test econometrically if the Fed’s Term Auction Facility (TAF), which is very similar in scope and collateral to the ECB’s traditional term refinancing operations, is successful in reducing interbank stress as measured by the LIBOR-OIS spread.

The econometric results are unambiguous: the Fed’s liquidity injections do not show a significant impact on the LIBOR-OIS spread. Rather, the spread is shown to be driven significantly by counterparty risk factors such as asset-backed commercial paper spreads, and credit default swaps for major banks, among other indicators. Since term lending operations do not affect counterparty risk, or total liquidity, and therefore neither the level of expected overnight rates in the future, the authors’ model rejects the hypothesis that term lending affects LIBOR-OIS spreads.

What else can central banks do? Here is an overview of additional tools the Fed is considering in order to address the ongoing stress in the money markets. In Europe, the ECB’s monetary policy framework (see table below) allows already for direct open market purchases of a broad range of marketable assets that are also eligible for collateral, including high-grade mortgage-backed securities. As Deutsche Bank notes, the ECB has not expanded its balance sheet in an unusual way except for a short period in December (see ECB liquidity injection timeline below.)

During its latest meeting the G7 decided against a coordinated intervention in distressed markets and Jean-Claude Trichet made it very clear during the March 26 hearing that governments must address solvency issues of any kind via taxpayer money if there is a will to do so, not via the central banks’ balance sheet. Moreover, as Daniel Gros pointed out in an earlier post, the ECB’s mandate does not include a lender-of-last-resort function with respect to single institutions (i.e. provide liquidity to a solvent but temporarily illiquid bank.); this function resides with national central banks.

The following are among the unanswered questions the authorities are presently working on:

  1. Is an emergency framework in place among national and super-national authorities?
  2. Is an adequate burden-sharing framework in place?
  3. How would the ECB react if a large cross-border counterparty was in trouble?

Appendix:

1. Definitions:

EURIBOR (Euro Interbank Offered Rate; LIBOR in U.S.): daily quotes of the average rate that representative panel banks quote one another for interbank term deposits within the Euro zone for maturities ranging from one week to one year. EURIBOR/LIBOR is the reference rate for most variable rate loans and interest rate derivatives.

EONIA (Euro OverNight Index Average; effective fed funds rate in U.S.) is the effective overnight lending rate computed as a weighted average of all effective overnight unsecured lending transactions in the interbank market

EONIA swap rate (Overnight Indexed Swap OIS in U.S.) reflects the panel banks’ expectations of the overnight lending rate over the next n days. This derivative is preferable to the simple EONIA rate (or fed funds rate in the U.S.) because the swap rate controls for changes in expectations as a factor in determining changes in interbank rates. Maturities range from 1 week to 2 years.

2. Monetary policy frameworks and central bank market operations

Source: BIS

3. ECB Term Lending Operation Timeline:

28 March 2008 – Supplementary six-month longer-term refinancing operations and continuation of the supplementary three-month longer-term refinancing operations: -two six-month LTRO of EUR 25 billion each -Two new supplementary three-month LTROs, with preset amounts of €50 billion each.

11 March 2008 – Specific measures to address liquidity pressures in funding markets: Joint action with the Federal Reserve by offering US dollar funding to Eurosystem counterparties $15 billion swap line.

7 February 2008 – Renewal of the supplementary longer-term refinancing operations of 23 November 2007 and 12 December 2007: – two supplementary LTROs with preset amount of EUR 60 billion

December 16 2008: ECB injected unprecedented EUR 348.6bn ($500bn) two-week repos (via FT)

12 December 2007 – Measures designed to address elevated pressures in short-term funding markets: – Joint action with the Federal Reserve by offering US dollar funding to Eurosystem counterparties $20 billion swap line.

8 November 2007 – Renewal of the supplementary longer-term refinancing operation allotted on 23 August 2007 and on 12 September 2007: -Two new supplementary with a preset amount of EUR 60 billion each

6 September 2007 – Pre-announcement of supplementary longer-term refinancing operation: variable rate tender, with no preset allotment amount.

22 August 2007 – Supplementary longer-term refinancing operation: maturity of three months for an amount of EUR 40 billion

14 August 2007 – Statement by Jean-Claude Trichet, President of the European Central Bank

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