The ECB and the crisis: what are the lessons? Lucrezia Reichlin London Business School and CEPR London School of Economics 20 November 2013

Outline What is special about the ECB? How much did the specific characteristics of the euro area framework limit its effectiveness during the crisis? Is there a general lesson beyond the experience of the euro area?

What is special about the ECB ? No fiscal backing Limitation of mandate No supervisory responsibilities until recently

ECB action TWO PHASES: 1.Global financial crisis Sovereign crisis and second recession 2011

PHASE 1 1.Global financial crisis 2008 characterized by “sudden stop” involving inter-bank transactions with non domestic financial institutions (run on the foreign part of inter-bank market – stable retail) ECB acts as a liquidity provider of last resort through the banking sector

THE ECB RESPONSE: MARKET OPERATION APPROACH TO LENDER OF LAST RESORT While the ECB has not adopted the rhetoric of “quantitative easing”, it has expanded its balance sheet, increasing reserves on the liabilities side against (largely) conventional assets (repos) on the asset side Liability side: allow increasing recourse to deposit facilities Asset side: expand scope of repo operations  The ECB largely dealt with banks by applying the pure version of the Bagehot rule  ECB was the most conventional but also the most aggressive of the central banks

THE SIZE OF THE LTRO - PROVIDING BANKS WITH LIQUIDITY Source: ECB

ECB INTERMEDIATION: THE EA, THE US AND THE UK Source: GS Global ECS Research As of end of January 2012 (using 2011 GDP figures)

Robustness of the framework: what have we learned? At the inception of the euro some questioned the robustness of the framework Would have the ECB been capable of act in response to a financial crisis? Tommaso Padoa Schioppa 2003: ``the framework is in place to act as a liquidity provider: market operation approach to lender of last resort’’ INDEED THIS WORKED

Symptoms : stabilization in 2 nd part of 2009 money market rates and spreads

NBER recessions datesCEPR recessions dates RECOVERY IN 2009Q2

12 OVERALL CONCLUSIONS OF QUANTITATIVE ANALYSIS: ECB NON STANDARD POLICIES 2008:9-2011:4 Rapid and effective response to a liquidity crisis. Followed the Bagheot rule: providing unlimited liquidity against collateral Financial stability function: avoided the melt-down Monetary policy function: some macro effects (see various papers …)

But limits which become clear in phase 2 Limits especially amplified by characteristics of the euro area financial markets (banks dominated financial sector; large cross-border banks) and lack of action on the solvency front

PHASE 2

WHAT WAS THE PROBLEM IN PHASE 2? 1.Banks not fixed in phase 1 (see chart) 2.Collateral deteriorates 3.Some banks became structurally dependent on the ECB 4. Sovereign problem starts gradually to emerge as a result of weak economic conditions and/or fiscal consequences of banking crisis …. Sovereign crisis erupts in 2010 and then 2011

Source: World Bank BANKS’ SOLVENCY PROBLEMS NOT FIXED

AND INCREASING PRESSURES ON GOVERNMENT FINANCES

FACING THIS SITUATION THE FINANCIAL SYSTEM BECOMES FRAGMENTED – STRONG HOME BIAS

Loans – retail (share of tot assets) GermanySpainFranceItaly Jul Gov. Bonds – domestic (share of tot assets) GermanySpainFranceItaly Jul BANKS INCREASINGLY HAVE INCENTIVES TO BUY GOVERNMENT BONDS OF THEIR OWN SOVEREIGN

CONSEQUENCE Correlation between bank risk and sovereign risk Difficult to distinguish banks’ debts from sovereign debt

ECB RESPONSE TO THE SOVEREIGN CRISIS AND ITS EFFECTIVENESS Intervention on sovereign bond market Trichet 2010 and 2011 : SMP1 (Greece) and SMP2 (Italy) Draghi: OMT More of the same on liquidity: Draghi 2012: LTRO2

The LTRO remains main tool Initially designed to deal with liquidity became a tool to address the solvency problem of banks and sovereign Lend to undercapitalized banks against collateral …. Keep insolvent banks alive ….. Provide incentive for banks to acquire government bonds to use as collateral less loans, more domestic government bonds in balance sheet

More of the same

BANKS BECOME INCREASINGLY DEPENDENT ON THE ECB: SPAIN AND ITALY ONLY AFTER 2011q3 Source: National Central Banks

BANKS, GOVERNMENT AND EURO-SYSTEM LIABILITIES: substitution but very little adjustment of size in total

Some key fiscal issues Close relationship between sovereign and the banking sector implies that market assessment of fiscal solvency involves consolidation of government and bank balance sheets In such a situation the provision of liquidity by the ECB through normal operations can become close to government financing, e.g.: –by continuing to roll over liquidity provision at its regular operations in large amounts at fixed rates, the ECB can sustain banks with solvency problems (which should be the responsibility of fiscal authorities); –by accepting newly issued government debt instruments as collateral, the ECB can provide indirect financing to governments ECB IS PARTY TO THE PROCESS OF ADDRESSING SOVEREIGN DEBT TENSIONS – INCREASING TENSIONS BETWEEN DEBTOR AND CREDITOR CONTRIES

Macro Effects?

Source: Eurostat Correlation between sovereign and bank’s risk reflected in retail rates

LOANS VOLATILITY: larger drop in the second cycle, conditionally to real economy

The 2011 recession in historical perspectives

KEY LESSONS LLR function designed to deal with liquidity – not solvency In a financial crisis liquidity and solvency issues difficult to distinguish ex-ante Non standard monetary policy implies assuming credit risk in central bank b/s. This is a fiscal issue This is okay provided that liquidity policy is complemented with action on solvency – essentially fiscal In a debt crisis banks’ debt and sovereign debt indistinguishable – need to deal with both In absence of action on this monetary policy function also impaired and banks are key in the transmission mechanism

What if … Some have argued that the ECB should have done pure QE But could the ECB have solved the debt problem of Italy and Greece?

General question CAN THE CB BUY ALL GOVERNMENT DEBT? Under fiat money no limitation for a LLR but the creation of base money has fiscal implications The b/s capacity of the CB is its fiscal capacity (if liability backed by collateral the limit is the potential loss; if backed by government debt the limit is future taxes) What matters is the consolidated b/s of governments and banks and whether this is compatible with price stability

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