Blog Post

The nod-and-wink lender of last resort

At his press conference on December 4, 2014, the ECB President Mario Draghi was asked if the ECB would be pari passu with other creditors. Mr. Draghi replied: “[…] we don't want to cause unintended monetary policy tightening in choosing forms of seniority which would be counter-productive. You all see this point, I believe.” I certainly did not see the point, but not for want of trying.

By: Date: January 13, 2015 Topic: Macroeconomic policy

At his press conference on December 4, 2014, the ECB President Mario Draghi was asked if the ECB would be pari passu with other creditors. Mr. Draghi replied:

“[…] we don’t want to cause unintended monetary policy tightening in choosing forms of seniority which would be counter-productive. You all see this point, I believe.”

I certainly did not see the point, but not for want of trying. The issue is a simple one. If the ECB buys the bonds of a eurozone sovereign and the sovereign is unable to repay in full, then would the ECB bear the same loss as the private creditors?

It was something of a relief when the ECB Governing Council Member Benoit Coeure clarified the principle of how the ECB is required to operate: 

"It is illegal and contrary to the treaty to reschedule a debt of a state held by a central bank. The European treaties are very clear on this."

In other words, the ECB must be repaid in full.

This arcane exchange is central to the ECB’s future, not only for its proposed “quantitative easing” plans but also for its Outright Transactions (OMT) programme. Tomorrow Advocate General Pedro Cruz Villalon of the European Court of Justice (ECJ) will deliver  a much awaited opinion on the German Constitutional Court’s challenge of the OMT.  The opinion will be considered by the ECJ, which is expected to reach its judgment by May this year.

The OMT finally created the basis for the ECB to function as a lender of last resort.

The OMT brought calm to the eurozone in the midst of one its recurring existential crises and, as importantly to its supporters, it finally created the basis for the ECB to function as a lender of last resort.  The German Court, however, was not persuaded. A lender of last resort to sovereigns helps them tide over temporary payment difficulties. The OMT, the German Court said would bailout insolvent governments.

The German Court’s challenge rests on two features of the OMT: the ECB’s promise to buy unlimited quantities of the bonds and its willingness to be pari passu with private creditors—in other words, if the sovereign were to default on its repayment obligation, the ECB would bear the same loss as the private creditors.

On both these core OMT features, the ECB has adopted a “nod-and-wink” approach. On unlimited purchases, Jorg Asmussen, a former Governing Council Member, said in his submission to the German Court:

“[…] we announced that our OMT interventions would be ex ante ‘unlimited.’ We have no doubt that this strong signal was required in order to convince market participants of our seriousness and decisiveness in pursuing the objective of price stability. At the same time, however, the design of OMTs makes it clear to everyone that the programme is effectively limited, for one by the restriction to the shorter part of the yield curve and the resulting limited pool of bonds which may actually be purchased.” 

In other words, the OMT would be described as unlimited because otherwise markets would not be reassured, but it would be effectively limited because otherwise it would violate the European Union’s Lisbon Treaty.

A more serious disconnect applies to the pari passu provision. In its Press Release announcing the OMT, the ECB said: 

“The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.

the ECB stepped beyond the traditional central banking domain of managing temporary financial disruptions into the sovereign insolvency arena. 

In emphasizing its acceptance of pari passu status, the ECB recognized that financial markets were principally interested in being relieved of the full burden of default. Thus, the ECB stepped beyond the traditional central banking domain of managing temporary financial disruptions into the sovereign insolvency arena. 

The pari passu provision is the OMT’s distinguishing feature and the key reason that made it a market favorite. The OMT’s earlier incarnation—the Securities Markets Programme (SMP)—was discredited precisely because the ECB overrode the pari passu requirement on its holdings of Greek debt. The bond contracts had specified the sharing of losses; but when those bonds were restructured in March 2012, the ECB exchanged the distressed bonds—in a side-deal with the Greek government—for new bonds that were not subject to the losses imposed on private creditors. Thus, the ECB remained whole. This, of course, meant larger losses were borne by bondholders whose securities were not purchased by the ECB. The adverse reaction that followed required that the OMT be seen to relinquish the ECB’s “seniority” claim—the claim to being repaid ahead all others. 

The German Court has concluded that such promised equal treatment in creditor status renders the OMT unconstitutional since it increases the likelihood of a “debt cut”—the risk that the ECB will not be repaid in full—and that contravenes the Treaty. That is exactly the same as Mr. Coeure’s interpretation. And, indeed, as I have argued, that is also the ECJ’s interpretation, with particularly strong strictures against the ECB taking on a sovereign’s commitments.

how unlimited are “unlimited” purchases of sovereign bonds and can the ECB legally accept losses on par with private creditors?

Of primary interest in Advocate General Pedro Cruz Villalon’s opinion will be whether and how he reinterprets the past ECJ position on no bailout of sovereigns. His answers to the two central questions will be critical: how unlimited are “unlimited” purchases of sovereign bonds and can the ECB legally accept losses on par with private creditors? Absent clear answers, the nod-and-wink strategy will continue. That, however, will be in an invitation for markets to test the ECB’s word and resolve. And the test, sovereign attorneys Lee Buchheit and Mitu Gulati predict could be merciless. 

Read more: 

Pulling the eurozone back from the brink

The ECB’s balance sheet, if needed

Did the German court do Europe a favour?

The OMT programme was justified but the fiscal union question remains


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article
 

Blog Post

European governance

Opaque and ill-defined: the problems with Europe’s IPCEI subsidy framework

Lack of strict governance and transparency creates serious risk that fair competition within the single market will be undermined. Fundamental overhaul of the framework is needed.

By: Niclas Poitiers and Pauline Weil Topic: European governance, Macroeconomic policy Date: January 26, 2022
Read article More by this author
 

Podcast

Podcast

Turkey’s economic struggles

Will inflation continue to surge?

By: The Sound of Economics Topic: Global economy and trade, Macroeconomic policy Date: January 26, 2022
Read article More by this author
 

Opinion

European governance

The euro comes of age

A well-functioning euro reflects a degree of unity that allows the EU to credibly claim a position at the global table and therefore help shape the policies that will deal with global problems. That is a decisive success.

By: Maria Demertzis Topic: European governance, Macroeconomic policy Date: January 13, 2022
Read article More on this topic More by this author
 

Opinion

A role for the Recovery and Resilience Facility in a new fiscal framework

Discussions on reforming European Union fiscal rules must consider a more permanent but targeted role for the Recovery and Resilience fund to meet climate ambitions.

By: Maria Demertzis Topic: Macroeconomic policy Date: January 10, 2022
Read article More by this author
 

Podcast

Podcast

The European economy in 2022

What are the economic priorities for the new year?

By: The Sound of Economics Topic: European governance, Macroeconomic policy Date: January 5, 2022
Read article More by this author
 

Opinion

European governance

The Euro at 20

The euro’s advocates hoped that the single currency would deliver economic and financial integration, policy convergence, political amalgamation, and global influence. While these predictions were often wide of the mark, the euro has arguably proven to be a wise investment.

By: Jean Pisani-Ferry Topic: European governance, Macroeconomic policy Date: January 3, 2022
Read article
 

Blog Post

European governanceInclusive growth

12 Charts for 21

A selection of charts from Bruegel’s weekly newsletter, analysis of the year and what it meant for the economy in Europe and the world.

By: Hèctor Badenes, Henry Naylor, Giuseppe Porcaro and Yuyun Zhan Topic: Banking and capital markets, Digital economy and innovation, European governance, Global economy and trade, Green economy, Inclusive growth, Macroeconomic policy Date: December 21, 2021
Read article
 

Blog Post

European governance

Policy coordination failures in the euro area: not just an outcome, but by design

Discussions on the fiscal framework should aim to correct its procyclical nature with a view to promoting more cooperative outcomes.

By: Maria Demertzis and Nicola Viegi Topic: European governance, Macroeconomic policy Date: December 20, 2021
Read article
 

External Publication

European governance

EU borrowing—time to think of the generation after next

Financing post-pandemic recovery via EU borrowing has proved remarkably straightforward. So why keep it temporary?

By: Grégory Claeys, Rebecca Christie and Pauline Weil Topic: European governance, Macroeconomic policy Date: December 9, 2021
Read article More on this topic More by this author
 

Opinion

Inflation ideology: camp permanent or camp temporary?

Policy focus should be on tackling uncertainties by being able to tackle as many scenarios as possible.

By: Maria Demertzis Topic: Macroeconomic policy Date: December 9, 2021
Read about event More on this topic
 

Past Event

Past Event

Fiscal policy and rules after the pandemic

What are the possibilities for shaping the new fiscal policy?

Speakers: Zsolt Darvas, Maria Demertzis, Michel Heijdra and Katja Lautar Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: November 24, 2021
Read article
 

Blog Post

European governance

Including home-ownership costs in the inflation indicator is not just a technical issue

The European Central Bank is right to propose inclusion of owner-occupied housing services in the inflation indicator. But the ECB’s preferred method would involve an asset price in the consumer inflation indicator.

By: Zsolt Darvas and Catarina Martins Topic: European governance, Macroeconomic policy Date: November 18, 2021
Load more posts