ES (03/2024) The Eurosystem’s operational framework Flashcards
[Introduction]
What has been the trend in the volume of reserves since the pandemic and why?
The volume of reserves has started to decline significantly due to a sharp reversal in monetary policy aimed at combating post-pandemic inflation and banks repaying their outstanding TLTRO loans, along with the maturity of bonds held by the Eurosystem without reinvestment.
[Introduction]
How much has excess liquidity in the Eurosystem changed, and what are future projections?
Excess liquidity has fallen by about €1.2 trillion from a peak of nearly €4.7 trillion in mid-2022, with expectations of a further decline of €1.4 trillion by the end of 2025, bringing it down to around €2.1 trillion.
[Introduction]
What is the focus of the Eurosystem’s operational framework discussed in the remarks?
The Eurosystem’s operational framework, tailored to the distinctive features of the euro area economy, aims to assist financial markets and banks in adapting to the ongoing changes in the liquidity environment.
[Taking stock of 25 years of policy implementation]
How did the Eurosystem’s monetary policy implementation change in response to the global financial crisis in 2008?
Following the global financial crisis, the Eurosystem shifted from a corridor system to using a fixed-rate full allotment tender procedure (un système d’adjudication intégrale à taux fixe) for all lending operations, allowing banks to determine the amount of liquidity they needed against a broad set of collateral, significantly changing the implementation of monetary policy in the euro area.
[Taking stock of 25 years of policy implementation]
How did the ECB’s response to the euro area sovereign debt crisis in 2011 and 2012 affect money market rates?
In response to the euro area sovereign debt crisis, the ECB launched three-year longer-term refinancing operations (LTROs) in 2011 and 2012, which significantly increased excess liquidity and pushed money market rates down from levels close to the main refinancing operations rate to the deposit facility rate, effectively reducing short-term money market rates by about 70 basis points.
[Taking stock of 25 years of policy implementation]
What impact did the asset purchase programme (APP) initiated in 2015 have on euro area liquidity and money market rates?
The APP led to the creation of new central bank reserves, increasing excess liquidity to levels that kept money market rates closely anchored around the deposit facility rate (DFR), showing the significant influence of central bank asset purchases on liquidity conditions and interest rate levels.
[Taking stock of 25 years of policy implementation]
What challenges emerged from the Eurosystem’s experience with abundant liquidity
Challenges included
- leakiness in the floor system, where excess liquidity led to a widening spread between the DFR and the euro short-term rate (€STR);
- discouragement of banks from seeking market-based funding, affecting their market testing of credit quality;
- and reduced market functioning due to the scarcity of safe assets, impacting the speed of monetary policy transmission.
[Taking stock of 25 years of policy implementation]
What was one notable consequence of the increased liquidity following the pandemic emergency purchase programme (PEPP) launched in 2020?
The PEPP resulted in unprecedented levels of excess liquidity, which revealed weaknesses in the Eurosystem’s floor system due to the steady widening of the spread between the DFR and €STR throughout 2021 and 2022, indicating challenges in controlling interest rates precisely even in a supply-driven floor system.
[Taking stock of 25 years of policy implementation]
How did the provision of ample reserves affect the financial market behavior of banks?
The availability of ample reserves led many banks to use targeted longer-term refinancing operations (TLTROs) to reduce their market borrowing, decreasing commercial paper issuance and other liabilities, which limited their opportunities to validate their credit quality in financial markets.
[Taking stock of 25 years of policy implementation]
What were the repercussions of asset scarcity on market dynamics and monetary policy transmission in 2022?
Asset scarcity, particularly of German government bonds used as collateral in repo transactions, resulted in trading rates significantly below the €STR, indicating a shortage of safe assets that delayed the transmission of monetary policy decisions, particularly in the repo market segments.
[Refinancing operations are at the centre of liquidity provision]
What central role do refinancing operations play in the Eurosystem’s operational framework?
Refinancing operations are at the core of liquidity provision in the Eurosystem’s operational framework, with the marginal unit of reserves provided on demand through regular refinancing operations such as the Main Refinancing Operations (MROs) and three-month longer-term refinancing operations against broad collateral.
[Refinancing operations are at the centre of liquidity provision]
Why might banks wish to hold larger liquidity buffers in the current financial environment?
Banks may prefer larger liquidity buffers due to
- years of financial crises,
- stricter regulatory requirements,
- and the potential risks of “digital” bank runs facilitated by new technologies,
which increase the importance of having readily available reserves.
[Refinancing operations are at the centre of liquidity provision]
How does the current framework ensure liquidity reaches all areas of the euro area effectively?
By centralizing refinancing operations and providing reserves against a broad set of collateral, the framework ensures that liquidity is distributed more evenly across the entire euro area, contrasting with asset purchases that tend to concentrate liquidity among larger financial institutions in a few member countries.
[A broad mix of instruments ensures operational robustness]
What future plans does the Eurosystem have to stabilize the supply of liquidity?
The Eurosystem plans to introduce new longer-term lending operations and establish a new structural bond portfolio to provide a more stable and reliable source of liquidity to banks, complementing the short-term lending operations.
[A broad mix of instruments ensures operational robustness]
How does the current liquidity balance reflect the role of legacy bond holdings? What changes are anticipated as the APP and PEPP portfolios are reduced?
- Currently, the liquidity absorption due to autonomous factors and minimum reserve requirements is more than offset by the liquidity provided through legacy bond holdings from the Asset Purchase Programme (APP) and the Pandemic Emergency Purchase Programme (PEPP), as well as other financial assets held by national central banks.
- As the APP and PEPP portfolios run down, banks will increasingly need to borrow reserves from the Eurosystem, which will likely lead to an increase in liquidity demand at regular Eurosystem operations. In response, the Eurosystem plans to begin supplying reserves through new longer-term refinancing operations and the new structural bond portfolio.
