The ECB’s Non-standard Measures during the Current Financial Crisis The ECB’s Non-standard Measures during the Current Financial Crisis

Speech by José Manuel González-Páramo, Member of the Executive Board of the ECB,ECB Workshop “The Macroeconomic Impact of Non-standard Monetary Policy Measures” Frankfurt am Main, 24 March 2011,

Introduction

Let me start by thanking you for participating in this workshop. I am delighted to see that researchers and practitioners from many central banks, international institutions and universities have met together here in Frankfurt to discuss important policy issues. As mentioned by my colleague Jürgen earlier this morning, in the Executive Board of the ECB we believe that examining the role and rationale of non-standard measures from an international perspective will provide important insights for both academic research and policy design.

There is no doubt that the global dimension of the recent financial turmoil has been one of its distinguishing features. By magnifying the impact of the crisis, its global nature obviously poses problems for policy making. But it also has some benefits from a research perspective. In particular, the international dimension of crises provides a valuable source of cross-country variation that can be exploited for economic analysis. For instance, in the case of the Great Depression, international comparisons have been used to demonstrate that countries which abandoned the gold standard rapidly were able to recover more quickly and escape deflation. ^[1]

In this respect, it is fair to say that central banks around the world have learned the lessons from previous crises. The policy response triggered by the recent financial turmoil has been rapid and measures of unprecedented magnitude have been introduced. Even if the true counterfactual scenario will never been known with certainty, the evidence available so far confirms that the global policy response has helped to mitigate the effects of the financial crisis.

It is however too early to declare victory. As the Great Depression has taught us, the conduct of monetary policy in a post-crisis environment is particularly challenging. ^[2] The initial measures have been effective but the sustainability of the recovery will very much depend on the reforms and interventions that will be taken in the next few months.

In this respect, I find the structure of this workshop, which brings both an academic and a policy perspective to the issue of non-standard measures, particularly appropriate. Comparing approaches and experiences across countries has helped us to understand the past and will certainly play a major role in the years to come.

In the remaining part of my presentation, I would like to share with you some thoughts on our experience with non-standard measures. I will briefly describe the non-standard measures adopted by ECB and their underlying rationale.

The Design and the Rationale for Non-standard Measures

The smooth functioning of financial markets which characterised the so-called Great Moderation came to an end in the second half of 2007. In its initial stages, the main focus of the turmoil was on the money markets. Interbank lending declined, banks hoarded liquidity, and the traditional patterns of arbitrage among interest rates in different market segments and at different maturities were disrupted.

After the collapse of Lehman Brothers, the ‘turmoil’ mutated into a fully-fledged ‘financial crisis’. Growing uncertainty and rising perceptions of counterparty risk led to the ‘seizing up’ of many market segments. Money market spreads shot up to unprecedented levels (see slide 1). At this point, the crisis spread decisively to the real economy: the "Great Moderation" gave way to the "Great Recession", characterised by the largest fall in output since World War II and a sharp contraction of world trade (see slide 2).

The ECB’s response to the crisis was swift and combined a mix of standard and non-standard monetary actions.

As regards the former, official interest rates were cut in a sequence of steps, bringing the main refinancing rate from 4.25% to 1% in the space of 6 months (see slide 3). The first of these reductions – on October 8, 2008 – was part of a concerted move with other major central banks, including the Federal Reserve, Sveriges Riksbank, the Bank of Canada, the Swiss National Bank, and the Bank of England. This decision was also endorsed by the Bank of Japan.

In order to meet banks’ increased demand for liquidity and to reduce uncertainty, a number of measures, which we have characterised as our “enhanced credit support” policy, were adopted. Overall, these measures helped to ease asset side constraints on banks’ balance sheets, thereby diminishing the risk of fire sales. Moreover, the introduction of additional longer term financing operations allowed banks to attenuate the mismatch between the investment side and funding side of their balance sheets and reduced the uncertainty regarding the supply of liquidity. As a result of these developments, intermediation which had previously taken place via the interbank market was replaced to a significant extent by intermediation via the ECB's balance sheet.

Like various other central banks, the Eurosystem has also embarked on outright purchases of securities, though on a relatively limited scale, in order to support the broader functioning of euro area financial markets. This marked a significant departure from the pre-crisis framework of monetary policy operations, which had been wholly based on repo transactions with counterparties and had never involved any outright monetary policy portfolio.

The Covered Bond Purchase Programme was initiated in June 2009. Before the failure of Lehman, covered bonds were a major source of funds for banks in the euro area. However, the spill-over effects connected with the intensification of the financial crisis in September 2008 led to a virtual shut down of the market, notwithstanding the high credit quality of this type of asset. In order to revive this segment of the market and thereby improving wider banking funding conditions, the Eurosystem purchased EUR 60bn of covered bonds between June 2009 and June 2010.

Not least due to strong and timely action by central banks and governments worldwide signs of stabilisation in financial markets emerged, with spreads returning to pre-Lehmann levels and positive output growth resuming in the beginning of 2010 (see slide 4). In this respect, and as will be discussed by the Vice-President this evening, the ECB’s non-standard measures seem to have played a nonnegligible role in supporting the euro area economy. The evidence available so far suggests that the non-standard measures have been effective and this conclusion is robust across methodologies. ^[3]

The improvement in market conditions continued until the outbreak of the European sovereign debt crisis in May 2010, when government bond markets in some countries threatened to seize up.

Given the central role played by sovereign debt in financial markets – for example, as an important source of collateral for repo operations and a basis for the pricing of other securities – such malfunctioning threatened both financial stability and the transmission of monetary policy. Even if the initial problems were focused on the Greek government debt market, contagion and spillover effects quickly spread to other so-called peripheral country sovereigns and to other market segments (see slide 5). In this context, in May 2010 the Eurosystem launched its Securities Markets Programme (SMP), which entailed the outright purchase of debt instruments.

By re-introducing some liquidity into the secondary market, these purchases have helped to re-establish more meaningful pricing of debt instruments of the sovereign markets most adversely affected by the crisis, thereby allowing market participants to recognise losses and unwind positions. Through such mechanisms, market functioning in other market segments has been able to resume and the transmission of monetary policy has been restored.

The absence of market liquidity and thus uncertainty about prices in one relatively narrow market segment can quickly spread to other markets if doubts emerge about the solvency or liquidity of some market participants with large exposures, even if they are fundamentally sound. In this context, the Eurosystem has placed a premium on maintaining market functioning and thereby a meaningful market price. While this will not prevent that some market participants face losses, the ability to recognise these losses and close positions can reduce the uncertainty and thereby contain the spillover effects.

A key distinguishing feature of asset purchases made under the SMP is that their liquidity impact has been sterilised through the conduct of weekly liquidity absorbing operations. Overall, there has been no net injection of central bank liquidity to the market as a consequence of these operations. These measures and their objectives are therefore fundamentally different from quantitative easing. For the ECB, non-standard measures have always been seen as a means of coping with abnormal functioning of some key markets, which, if unaddressed, would have posed problems for the effective transmission of monetary policy. This implies that, for the ECB, standard and non-standard measures are complements, not substitutes. We have never chosen non-standard measures as alternatives or substitutes for changes in official interest rates. Indeed our standard and non-standard measures were implemented in parallel.

To a large extent, this outcome reflected the fact that the ECB was not in the event constrained by the zero lower bound on nominal interest rates. In a situation in which official interest rates have reached the lower bound yet further monetary stimulus is deemed desirable, then non-standard measures can in principle be employed in order to providing extra stimulus to the economy. This has clearly been the case with regard to quantitative easing in the US and the UK. Undoubtedly the measures adopted by the ECB did lead to an expansion in the central bank balance sheet and increases in the money base. However, this was a consequence, not an explicit objective of the measures taken.

Limits and Costs of Non-standard Measures

As the Great Depression has taught us, in the face of a crisis of this magnitude, the cost of inaction can be substantial. The ECB and other central banks around the world took their responsibility by implementing measures which were needed to prevent a collapse of the financial system.

During the crisis, for the first time in the short economic history of the euro area, the annual growth rate of the main monetary aggregate sharply fell over a very protracted period and even turned negative (see slide 6). Given our knowledge of the Great Depression, the fact that the growth rate of money supply has stabilized and then started to increase again is reassuring.

While the available evidence, which is examined in greater detail in this workshop, suggests that non-standard measures have been effective, it is however too early to draw definitive conclusions. More time will be needed to assess the longer term impact of the policies that have been implemented throughout the world. Whereas chaotic bankruptcies and financial panics can alter the allocation of resources, if extended for too long liquidity assistance to the banking sector can create disruptions that can be equally damaging. In this respect, the fact that – nearly four years after the start of the turmoil – some banks continue to be dependent on central bank funding is disconcerting. Like the effects of antibiotics on the human body, non-standard measures have side effects that have the potential to create serious disruptions.

The problem of dependent banks is a reminder that non-standard measures come at a cost and that central bank intermediation has to remain an option of last resort. The assistance provided to the banking sector should only be a temporary measure that will be extended as long as necessary, but which needs to be phased out as soon as possible.

The same applies to the Security Market Programme. Acting as a lender of last resort – or, perhaps more accurately, an intermediator or market maker of last resort – by providing liquidity to the most affected markets, the Eurosystem has helped to contain market stress. But these measures – by their nature – cannot solve the fundamental institutional, solvency and structural problems that caused the financial and sovereign crises in the first instance.

Conclusion

To conclude, the combination of standard and non-standard measures deployed by the ECB and other central banks has been effective in averting a full-blown financial collapse. Nonetheless, the exceptional nature of, and the risks associated with, non-standard measures imply that these measures must be phased out as soon as circumstances permit.

In this respect, the flexibility of our operational framework – as reflected by the nature of the measures that the ECB has adopted - is an invaluable asset. The fact that the European Central Bank can remunerate reserves through its deposit facility implies that interest rates decisions are not constrained by the size of our balance sheet. This flexibility allows the Governing Council to completely choose the way in which interest rate actions could be combined with the unwinding of the non-standard measures.