ECB liquidity operations and monetary policy

What's at stake: President Trichet’s announcement before the European parliament that the return to the stricter collateral requirements originally foreseen by the end of 2010 will be postponed removes the risk of Greek Government Bonds being barred from the repo operations of the ECB. Instead, the ECB will introduce a sliding scale of haircuts for sovereign debt instead of the present flat structure for all Euro-zone sovereigns starting January 2011. Details will be provided on April 8 at the next monthly meeting, but one can clearly see that this change might end up not being so helpful for Greece if the haircuts imply high extra costs.  More broadly, this policy change poses the question as to whether ECB is in the middle of a broader turn around on its thinking about the relationship between liquidity operations and the conduct of monetary policy.

The FT Money Supply blog outlines that Trichet’s announcement was unexpected. After all, he was mum on the subject as recently as Monday, when he was also in the European Parliament. Still, those who watch these things closely had always guessed the ECB would have to back down eventually, given the pressure on Greece over its public finances. The blog also reports that few punters wanted this week’s final unlimited three- and six- month debt offers from the ECB. In future auctions, banks will compete for funds, as they used to. Banks can still bid for debt through the ECB’s weekly main refinancing operations. Focus will now shift to the removal of one-year liquidity in July of this year - the final part of the exit from unlimited funds provision.

Jacob Funk Kirkegaard argues that taking the nuclear option off the table paves the way for a more “flexible response” system of collateral requirements by the ECB, such as a risk-weighted system in which risky Greek debt would carry a higher penalty than German bonds. This ECB gesture would reduce liquidity risk, helping to lower Greece’s cost of capital during 2010 more effectively than what the eurozone decided with its rescue plan. Certainly, it brings the ECB closer to a traditional role as the de facto lender of last resort for a crisis country. Cédric Tille, however, argues that decision implies a risk that the ECB will not be resolved in the future to maintain quality criteria of the collateral which it accepts when it represents a problem for certain banks of the Eurozone.

Erik Nielsen argues that the sliding scale of haircuts should be determined by a broad set of measures with the rating agencies being only a complement to a more facts based assessment. Specifically, the scale determining the size of haircuts should be a combined average of the three leading agencies and the ECB's own assessment, based on a transparent set of objective quantitative indicators. Such indicators should cover both structural and cyclical measures of government deficit and debt ratios. Weighting them all together with the average ratings would then produce one key index number that could be pared back with a haircut.

Shahin Vallée writes that the ECB formalised (without making it public) actionable agreements for proper FX swap lines (euro vs. local currency) with the National Bank of Hungary and the National Bank of Poland in October 2009. This represents an important shift in the ECB’s liquidity provision policy towards acceding eurozone members. The ECB’s previous ‘liquidity lines’ treated the two CEE central banks in question as commercial banks in the eurozone; allowing them to repo eligible ECB collateral in return for euro cash. The ECB argued it was better to supply euro liquidity indirectly to CEE economies via the eurozone banks that had sizeable CEE operations in the countries. The idea being that these banks would be much more effective at channelling the liquidity where it was needed. Beyond the issue of whether it was more efficient to proceed this way, the ECB’s approach reveals a profound failure of transparency, as information and policy justifications are still withheld from the public. It was, indeed, never clear why the ECB refused formal FX swap lines to CEE countries in the first place, nor why it preferred those strange ad hoc liquidity lines anyway.

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