“Monetary and Financial Stability”
The Flexibility of the Monetary Policy Tools of the European
Central Bank – a Case Study Referring to the International
Liquidity Crisis 2007/2008
Dr. Dietrich Schönwitz, Honourable Professor
1. Introduction: On the relevance of soft factors in economics and the
liquidity crisis 2007
2. What happened first: Houseprice bubble and subprime mortgage defaults
in the US
3. Transmission of turbulences to the money markets by structured financial
innovations and risky refinancing behaviour
4. Liquidity crisis as confidence crisis
5. The ECB’s concept and practice of crisis management
5.1. Acceptance of lender of last resort commitment
5.2. The ECB’s flexible liquidity management
5.2.1. Operational target and money market rates
5.2.2. Additional open market operations accompanied by ad hoc communication
5.2.3. Conclusion: Clear distinction between confidence crisis tensions and overall
6. From liquidity crisis to a multiple caused capital demand crisis 2007/08
7. Lessons and some proposals – a tentative approach
Chart 1: The importance of soft factors
I hope, we will be able to improve confidence. Confidence is essential to
prevent spillover effects of the financial turbulences to the real economy.
Joaquin Almunia, EU-Commission, in October 2007
It’s the psychology that leads to panics and recessions.
Alan Greenspan, former Chairman of the FED, in his biography, 2007
Chart 2: Origin of the liquidity crisis
The crisis began in the American province and not at Wall Street:
- promoted by very low interest rates and a liquidity surplus
- risky subprime mortgages for people with low income and standing (100 %
credits, 2/28 mortgages, “Ninja-loans”)
- irrational exuberance on both sides of the loan market
- house price “bubble”
- estimation of possible subprime defaults: 20 %.
“...we are deeply concerned about the potential contagion effect from poorly
underwritten or unsuitable mortgage and home equity loans.”
(Association of Mortgage Insurance Companies of America - MICA, July 2006)
The warning from MICA came exactly one year before the money market
turbulences in the US, in the Euro Area and in Great Britain began and central
bank’s assistance actions started.
Chart 3: Transmission to the money markets
Spread of risks around the world by securitisation and OTD-behaviour.
- Asset Backed Securities (ABS) respectively Mortgage Backed Securities (MBS)
- possibility to sell risks and get them out of the books
- estimation: for about 50% of the mortgage loans in America in 2005 and 2006
MBS were issued.
Structured products as Collateralised Debt Obligations (CDO’s) affected
transparency and adequate rating of risks.
Conduits and Structured Investment Vehicles (SIV’s) financed capital market
investments in CDO’s short by revolving Asset Backed Commercial Paper (ABCP)
issue on the moneymarket and thereby did not follow the traditional banking
principle of machting maturities.
Transmission of turbulences to the money markets because of subprime defaults,
dried up ABCP market, credit line involvement and loss of confidence.
Even banks with a liquidity surplus cancelled their credit lines to counterparts as
soon as possible.
The Governing Council of the ECB accepted a lender of last resort commitment to
the money market because the risk of a systemic crisis affecting even otherwise
This was a deliberate decision without undue hesitation against a “hands-off-
concept” because of moral hazard apprehension and bail out arguments.
Flexible liquidity management in addition to the prescheduled refinancing
operations to provide central bank liquidity and restore confidence, no
interventions on the capital market.
Chart 5: The Euro money market – an overview
(maturity up to 1 year)
Central Bank Money Bank Deposit
(base money) Money
Regulated Money rate variations
Influenced by ECB‘s open Banks deal with base
market operations with money (redistribution);
banks to fulfil their EONIA (= Euro Overnight
liquidity need and to Index Average) and three
signal the monetary policy months EURIBOR (= Euro
stance by variations of Interbank Offered Rate)
the operational rate. are important reference
Chart 6: Eurosystem’s tools of monetary policy
1. Revolving open market operations
- Longer term refinancing operations as variable rate tenders
- Main refinancing operations as variable rate tenders with minimum bid rate
2. Standing facilities
- Marginal lending facility
- Deposit facility
both have only marginal influence on the liquidity situation
3. Minimum reserve
causes 40% of the daily liquidity need
4. Fine tuning operations mainly at the end of a minimum reserve period to
provide or absorb liquidity resulting from wrong expectations
- Variable rate quick tenders with minimum bid rate (providing)
- Fixed rate quick tenders (absorbing)
both have only marginal influence on the liquidity situation
Chart 7: Money market liquidity
Chart 8: Careful communication
The ECB prepared and accompanied the additional tender operations by careful
communication to the public.
“The ECB notes that there are tensions in the euro money market, notwithstanding
the normal supply of aggregate euro liquidity. The ECB is closely monitoring the
situation and stands ready to act to assure orderly conditions on the euro
(Monthly Bulletin, Sept. 2007)
This follows the insight of modern central banking that management of
expectations by means of communication policy - by openness and not secrecy, by
transparency and not closed shop behaviour - contributes to the efficiency of
Communication of private banks to the public during the turbulences contributed
not always to the restoration of confidence (e.g. information about depriciations
with some delay).
Chart 9: Turbulences
minimum bid rate
Chart 10: ECB’s fine-tuning operations in August 2007
Rate (in %)
fixed (f) Number of
Date Maturity amount Bid-cover-ratio
minimum marginal average bidders
9 overnight 94.8 4.00 (f) - 4.00 49 1.00
10 overnight 61.1 4.00 (m) 4.05 4.08 62 1.80
13 overnight 47.7 4.00 (m) 4.06 4.07 59 1.77
14 overnight 7.7 4.00 (m) 4.07 4.07 41 5.97
Chart 11: Benchmark allottment
The daily liquidity need and the benchmark amount for central bank money
is determined by
• minimum reserve obligations
• currency in circulation
• foreign assets
• government deposits with the Eurosystem
Benchmark amount for main refinancing operations: Published weekly before an
operation; results from weekly prognoses of the above mentioned factors and
allows to fulfil the minimum reserve obligations; benchmark means orientation, not
necessarily real allottment.
Chart 12: EONIA – EURIBOR spread indicates longer lasting crisis
Source: Bundesverband Deutscher Banken.
In a second step after the
interventions the ECB
conducted additional longer
term operations with three
months maturity because an
increasing spread between
EONIA and EURIBOR
signalled special tensions on
the longer term end of the
money market. These
additional operations were
renewed to cover the year
end 2007/08 with special
liquidity demand and then until June 2008 because of spill-over effects to the money
market from the capital demand crisis. For April and July 2008 the ECB even announced to
conduct tender operations with 6 months maturity for the first time.
Chart 13: Conclusion of liquidity crisis management
Distinction between the confidence crisis tensions on the money market and the still existing –
but for a certain period not completely accessable liquidity surplus in the Euro Area.
“Against this background, and with money and credit growth vigorous in the Euro Area, the
ECB’s monetary policy stands ready to counter upside risks to price stability as required by its
primary objective.” (ECB, Monthly Bulletin, Oct. 2007)
Lender of last resort commitment, this is the clear message, does not imply a weakening of
the medium term price stability orientation, on the contrary. To manage and anchore
expectations in line with price stability “... is the more important at times of financial market
volatility and increased uncertainty.” (Jean Claude Trichet, President of the ECB, Press
Conference 9 November 2007)
Contrary to the FED and the BOE the ECB reacted to the crisis on the Euro money market
not with a reduction of the minimum bid interest rate – but with a combination of short term
and longer term liquidity management.
The net volume of base money liquidity created by additional open market operations
remained in 2007 – as before at about EUR 450 billion. But firstly the frequency increased
and secondly the structure of the liquidity supply changed to a front-loading and to a higher
amount of longer term supply.
Chart 14: Lender of last resort commitment?
Acceptance of lender of
last resort commitment
Criterion: liquidity crisis
(fear of systemic crisis)
Targeted direct liquidity Additional „indirect“ open market
assistance for single bank operations using the price (interest
rate) mechanism for allocation
Criterion: strict final target
commitment (price stability)
Yes: no increase of net No: liquidity surplus
volume of liquidity promoted by operational rate
Example: ECB‘s liquidity
management 2007/2008 Example: Fed‘s policy of easy
Eonia - Euribor spread
4,80 4,74 4,78
4,03 4,02 4,02
Euribor - 3M
Chart 16: Conclusion for capital demand support?
• Contra: “With every single state or central bank support the seed for the next
attack of the greedy is put in earth.”
• Pro: “The situation is too serious to stick to honourable principles.”
(Statements of central bank watchers, April 2008)
• “Righteousness must prevail, even if the world collapses.”
(Maxim of Ferdinand I., German-Roman Emperor, 1503 – 1564)
Is this really “righteous”?
Chart 17: ECB’s judgement
“ ... that the Eurosystem’s open market operations were broadly
successful in maintaining the average level of very short term
interbank money market rates close to the policy rate in this period
of greater than normal volatility, in particular at the beginning of the
financial market turmoil and in the period approaching the year-end.
Overall, the Eurosystem’s operational framework has proven fairly
resilient to the financial market turmoil and no structural changes
were needed to cope with the greater volatility.”
Source: ECB, Monthly Bulletin, April 2008.
Chart 18 (1/2): Ten proposals for further discussion
1. The possibility of a systemic crisis justifies to weigh a preemptive lender of last resort
commitment on the money market against moral hazard and bail out arguments.
2. The principle of subsidiarity should not be neglected (e.g. liquidity pool founded by the
3. A careful communication to the public, openness and not secrecy plus final target
orientation contribute to confidence (modern banking as management of expectations by
means of communication policy). Private banks should join this trend.
4. Preemptive orientation supports crisis prevention, requires monetary indicator
orientation and monetary analysis in addition to the analysis of economic indicators as
columns of central bank strategy.
5. Asset price valuations could be included directly into the monetary policy stance (policy
of “leaning against the wind” of an incoming bubble).
6. More transparency especially in context with structured financial innovations (CDO’s),
rating practices and off balance sheet Conduit and SIV practice is necessary.
7. The risk of irresponsible lending could be reduced if the originator of a structured
product is obliged to hold permanently a note of it and thereby remains personally
involved at risk.
Chart 18 (2/2): Ten proposals for further discussion
8. Capital-liquidity requirements (loan-to-value ratios) could be varied counter-cyclically.
9. Direct targeted capital support for single banks is not the “normal” operational
responsibility of the central bank. But with bank runs and a collapse of the global
financial system waiting in the wings it may be justified to cross the borderline. But then
public – and not individual - benefit from emergency liquidity assistance (ELA) should be
estimated higher in open and transparent calculation than the amount of expenditures.
10. Global problems should be solved globally. In this context countries with remarkable
forex reserves and currency account surplus may have a mission too. This, a code of
conduct and openness could contribute to the reduction of prejudices considering the
role of state funds.
Chart 19: Regulators fate
„There will always be intelligent people who find some back
door to outwit the regulator.“
Thank you very much for your attention!