2b The ECB

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There is little room for doubt, in my view, that the Fed under Greenspan treated the stability, well-being and profitability of the financial sector as an objective in its own right, regardless of whether this contributed to the Fed’s legal macroeconomic mandate of maximum employment and stable prices or to its financial stability mandate. Although the Bernanke Fed has but a short track record, its too often rather panicky and exaggerated reactions and actions since August 2007 suggest that it also may have a distorted and exaggerated view of the importance of the financial sector for macroeconomic stability.

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securities like residential mortgage-backed securities. The ratings requirements were also very loose compared to those of the Bank of England and even those of the Fed: eligible securities had to be rated at least in the single A category. The only dimension in which the ECB’s eligible collateral was more restricted than the Bank of England’s was that the ECB only accepts euro-denominated securities. More than 8000 banks were subject to the minimum reserve requirements of the Eurosystem and are therefore are eligible counterparties for Eurosystem open market operations and have access to its discount window.

The ECB was smart in using the available liquidity instruments quite aggressively, injecting above-normal amounts of liquidity against a wide range of collateral at longer maturities (and mopping most of it up again in the overnight market). It is important to note that injecting X amount of liquidity at the 3-month maturity and taking X amount of liquidity out at the overnight maturity is not neutral if the intensity of the liquidity crunch is not uniform across maturities. The liquidity crunch that started in August 2007 clearly was not.

Maturities of around 1 month were crucial for end-of-year reasons and maturities from 3 months to a year were crucial because that was where the markets had seized up completely.

The ECB consciously tried to influence Euribor-OIS spreads to the extent that it interpreted these as reflecting illiquidity and liquidity risk rather than credit risk.

No major Euro Area bank has failed so far. Some small German banks fell victim to unwise investments in the ABS markets, and some fairly small hedge funds failed, but no institution of systemic importance was jolted to the point that a special-purpose LLR rescue mission had to be organised.

I have one concern about the nature of the ECB’s liquidity-oriented open market operations and about its collateral policy at the discount window. This concerns the pricing of illiquid collateral offered by banks. We know the interest rates and fees charged for these

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operations, and the haircuts applied to the valuations. But we don’t know the valuations themselves. The ECB uses market prices when a functioning market exists. For some of the assets it accepts as collateral there is no market benchmark.

The ECB does not make the mistake the Fed makes in its pricing of the collateral offered at the PDCF and TSLF. The ECB itself determines the price/valuation of the collateral when there is no market price. But the ECB does not tell us what these prices are, nor does it put in the public domain the models or methodologies it uses to price the illiquid securities. Requests to ECB Governing Council members and to ECB and NCB officials to publish the models used to price illiquid securities and to publish, with an appropriate delay to deal with commercial sensitivity, the actual valuations of specific, individual items of collateral have fallen on deaf ears.

There is therefore a risk that banks use the ECB as lender of first resort rather than last resort, if the banks can dump low-grade collateral on the Fed and have it valued as high- grade collateral.³⁴ Since at least the beginning of 2008, persistent market talk has it that Spanish and Dutch banks may be in that game, getting an effective subsidy from the ECB and becoming overly dependent on the ECB as the funding source of first choice.

Late May 2008, Fitch Ratings reported that Spanish banks had, during recent months, created ABS, structured to be eligible for use as collateral with the ECB (strictly, with the NCBs that make up the Eurosystem), that were riskier than the ABS structures they put together before the crisis. Accepting higher-credit risk collateral need not imply a subsidy from the Eurosystem to the banks, as long as the valuation or pricing of these securities for collateral purposes reflects the higher degree of credit risk attached to them. One wonders whether such risk-sensitive pricing is actually taking place, especially when ECB officials

34 The probability of default on a collateralised loan like a repo is the joint probability of both the borrowing bank defaulting and the issuer of the security used as collateral defaulting. The probability of such a double default will be low but not zero under current circumstances. It may be quite high, when RMBS are offered as collateral, if the borrowing bank is also the bank that originated the mortgages backing the RMBS.

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publicly worry about the creditworthiness of securities accepted as collateral by the ECB when it provides liquidity to the markets or at the discount window.

As long as the risk-adjusted rate of return the ECB gets on its loans is appropriate, there is nothing inherently wrong with the ECB taking credit risk onto its balance sheet. But if it routinely values the mortgage-backed securities offered by the Spanish banks as if the mortgages backing the securities were virtually free of default risk, then the ECB is bound to be overvaluing the collateral it is offered. In the first half of 2008, Spanish commercial banks, heavily exposed to the Spanish construction and housing sector, are reported to have repoed at least € 46 bn worth of their (often illiquid) assets in exchange for ECB liquidity.

Participants in these repo transactions have told me that no mortgages offered, directly or indirectly, to the Eurosystem as collateral have been priced at less than 95 cents on the euro.

This seems generous given the dire straits the Spanish economy, and especially the housing and construction sector, now are in. Of course, haircuts are (as always) applied to these valuations.

It is essential that all the information required to verify whether the pricing of collateral accepted by the Eurosystem is subsidy-free be in the public domain. That information is not available today.

Because part of the collateral offered the Eurosystem is subject to default risk, there could be a case for concern even if ex-ante, the default risk is appropriately priced. In the event a default occurs (that is, if both the counterparty borrowing from the Eurosystem defaults and at the same time the issuer of the collateral defaults), the Eurosystem will suffer a capital loss. In practice, it would be one of the NCBs of the euro area that would suffer the loss rather than the ECB, as repos are conducted by the NCBs.

Although the ECB’s balance sheet is small and its capital tiny, the consolidated Eurosystem has a huge balance sheet and a large amount of capital (see Table 6). The

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balance sheet could probably stand a fair-sized capital loss. But there always is a capital loss so large that it would threaten the ability of the Eurosystem to remain solvent while adhering to its price stability mandate. The ECB/Eurosystem would need to be recapitalised, but by which national fiscal authorities and in which proportions? Unlike the Fed and the Bank of England, where it is clear which fiscal authority stands behind the central bank, that is, stands ready to recapitalise the central bank should the need arise, the fiscal vacuum within which the ECB, and to some degree the rest of the Eurosystem also, operate, leaves a question mark behind the question: who would bail out the ECB?

This question may not yet be urgent now, because even euro-area banks with large cross-border activities still tend to have fairly clear national identities. But this is changing.

Banca Antonveneto, the fourth largest Italian bank, is owned by ABN-AMRO, a Dutch bank which is now in turn owned by Royal Bank of Scotland (UK), Fortis (Belgium) and Santander (Spain). Would the Italian Treasury bail out Banca Antonveneto? Soon there will be banks incorporated not under national banking statutes but under European Law, as Societas Europaea. One large German financial group with banking interests, Allianz, has already done so. Given this uncertainty, it may be understandable that ECB officials are more concerned than Fed and Bank of England officials about carrying credit risk on the Eurosystem’s balance sheet.

Although the ECB has done well in its MMLR function, albeit with the major caveat as regards the pricing of illiquid collateral, its LLR ability has not yet been tested. This is perhaps just as well. The ECB has no formal supervisory or regulatory role vis-a-vis euro area banks. The Treaty neither rules out such a role nor does it require one. In practice, no regulatory and supervisory role for the ECB has as yet evolved. Banking sector regulation and supervision in the euro area is a mess. In some countries the central bank is regulator and supervisor. Spain, France, Ireland and the Netherlands are examples. In others the central

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bank shares these roles with another agency. Germany is an example with the Bundesbank and Federal Banking Supervisory Office (FBSO) sharing supervisory responsibilities. In yet other countries the central bank has no regulatory and supervisory role at all. Austria and Belgium are examples.

Since the crisis started, the ECB has complained regularly, and at times even publicly, about the lack of information it has at its disposal about potentially systemically important individual institutions. In the case of some euro area national regulators, there even exist legal obstacles to sharing information with the ECB. Compared to the Fed and the Bank of England, the ECB is therefore very close to the Bank of England which, when the crisis started, had essentially no individual institution-specific information at its disposal. The Fed, with its (shared) regulatory and supervisory role, has better information.

On the other hand, the ECB appears much less moved by the special pleading emanating from the euro area financial sector than the Fed appears to be by Wall Street. This is not surprising. Without a supervisory or regulatory role over euro area financial institutions and markets, regulatory capture is less likely.