Sat Feb 26th, 2011 at 02:57:31 PM EST
The reaction to my recent column on ECB liquidity management was generally one of puzzlement as the topic appears quite arcane, and due to its venue and audience the piece didn't lend itself to being particularly pedagogical though I did try to at least expand all acronyms once and to explain as much as possible.
Because I still think the issue is important (basically, exposing the mismanagement of Europe's economic affairs), and because I don't think it's that difficult either (if people don't get what I'm saying it, it has to be my fault), I have decided to start a series of pedagogical diaries on banking. And why would people want to learn about banking anyway? (other than how to burn one, that is) It so happens that banking is central to the Second Great Contraction (to borrow a term from Reinhart and Rogoff) that started in the summer of 2007 and still hasn't run its course, and which threatens to take no less than the Euro with it.
In this first instalment, I'll discuss bank reserves in the Eurosystem, which are intimately linked to the argument of my column last week.
The EONIA heartbeat
Interesting comment threads did develop about my column, in particular one started by afew
who broached the issue of overnight interbank lending rates, which were not part of my original argument. Trying to elucidate what was going on, I came up with the simile of the EONIA heartbeat
as the chart of interbank rates looked, to me at least, rather like an electrocardiogram:
This is a chart of interest rates for overnight lending among Eurozone banks. Overnight lending means that one bank borrows money from another at the close of business one day, and pays it back at the opening the following morning. This is part of the normal operations of the payment and clearing system. Basically, when anyone in the economy uses banks as payment intermediaries (by using cheques, cash cards or direct transfers from one bank account to another), two banks are usually involved, one for the payer and one for the payee. Because the banks are creditworthy, people accept cheques, plastic or a bank transfer record as proof of payment rather than demanding currency. But these means of payment result just in annotations in accounting ledgers (modernly, just in moving some bits around in some computers) and, if the bank of the payee is different from the bank of the payer, the payer's bank owes some money to the payee's bank. Now, banks sometimes exchange money in armored vans, but until that happens there's a net balance, which changes each day. And it is on this net balance at the end of each day that banks charge each other an overnight rate. This rate, for the Eurozone, is called EONIA:
Eonia® (Euro OverNight Index Average) is an effective overnight rate computed as a weighted average of all overnight unsecured lending transactions in the interbank market, initiated within the euro area by the contributing panel banks.
Note that EONIA is a rate of actual transactions that took place the night before, not a market quote that may have no money behind it.
Central Bank reserves
Why does EONIA display that monthly heatbeat pattern? The answer is the Central Bank. Banks do, in fact, have accounts at their Central Bank just like any firm or individual has an account at a regular bank, so they can settle debts among themselves by telling the Central Bank to transfer the requisite amounts between the commercial banks' accounts at the Central Bank. For this purpose, the European Central Bank requires banks to hold a minimum balance, called "reserves". For the Eurosystem, this is 2% of (most) liabilities, minus a lump sum allowance for small banks, and the balance is remunerated.
The European Central Bank (ECB) requires credit institutions to hold compulsory deposits on accounts with the national central banks (NCBs): these are called "minimum" or "required" reserves. The amount of required reserves to be held by each institution is determined by its reserve base.
In order to determine an institution's reserve requirement, the reserve base is multiplied by the reserve ratio. The ECB applies a uniform positive reserve ratio to most of the balance sheet items included in the reserve base. This reserve ratio was set at 2 % at the start of Stage Three of European Economic and Monetary Union (EMU). As noted above, the reserve requirement for each individual institution is calculated by applying the reserve ratio to the reserve base. Institutions can deduct a uniform lump-sum allowance from their reserve requirement. Since the start of Stage Three of EMU they have been entitled to deduct 100.000. This allowance is designed to reduce the administrative costs arising from managing very small reserve requirements.
The Eurosystem aims to ensure that the minimum reserve system neither puts a burden on the banking system in the euro area nor hinders the efficient allocation of resources. For this reason, credit institutions' holdings of required reserves are remunerated. The remuneration corresponds to the marginal rate (weighted according to the number of calendar days) of the main refinancing operations during the reserve maintenance period. This rate is therefore very close to the short-term money market rates.
And the reserve management causes these monthly spikes due to the existence of reserve maintenance periods. Basically, the minimum balance banks are required to keep in their deposit accounts is not a daily requirement (this could be costly and stressful to manage), but an average requirement over a so-called reserve maintenance period
. The chart above shows that the EONIA spikes on the last day of a reserve period and goes back down on the next day, which is the start of a new period. This is so because banks which happen to have a deficit of average reserves over a period borrow them from other banks which happen to have accumulated an excess of reserves, and there is a higher volume of interbank lending on that one day.
Central Bank overnight rates
In case a bank fails to maintain its reserves, the ECB will lend to them an unlimited amount (provided the bank can pledge assets of sufficient quality as collateral) at a penalty rate. This is called the Marginal Lending Facility
and the rate is represented in red in my chart. Currently it's at 1.75%. This sets an upper bound for EONIA as, were a bank unable to borrow from another bank overnight at a cheaper rate, they can always make up for their reserve shortfall by borrowing from the ECB.
There is also a green rate on the chart: that is the rate of the Deposit Facility, which is the rate that the ECB pays for excess reserves held at the ECB and is currently at 0.25%. Generally, a bank will rather lend to another bank at EONIA than park the money as excess reserves at the ECB, as long as the other bank pays more than the ECB's deposit rate. But if no other bank will borrow above the deposit rate, any excess cash will end up at the ECB collecting the deposit rate.
The EONIA heart develops tachycardia
So far, so good. Now let's look at what the EONIA has been doing lately (the attentive reader will have noticed my heartbeat chart doesn't extend past June 2010). I call this EONIA tachycardia
at Paul Spencer's suggestion in afew's thread:
This doesn't look too healthy. EONIA is shooting up to higher and higher levels at the end of each maintenance period, and staying elevated for weeks on end. This is an indication that interbank liquidity is very tight, in fact as tight on any given day as would be typical for the rollover day from one reserve maintenance period to the next. Curiously, however, it's not just a matter of EONIA going higher. For some time each maintenance period, overnight lending drops back near the deposit rate. So the widening range of oscillation of EONIA is the salient feature. We'll return to this later.
I have marked the date of May 10, 2010, which is when the ECB started buying sovereign Euro bonds (SMP stands for "Securities Market Programme", the ECB's obscure name for these purchases) and "sterilizing those purchases". As argued in my column, those purchases have no monetary impact, but the "sterilization" (drawing cash from the system in an amount equal to the bond purchases) is causing tight liquidity conditions in the interbank market. So my claim was basically that the EONIA tachycardia is evidence that the ECB's "sterilization" is a mistake.
The repo rate
At this point, one might like to take a longer view. After all, the "heartbeat" spans a period where the banking system was still recovering from the worst of the crisis, so it could be an unnatural pattern. Here's the history of EONIA since the beginning of the Euro:
Going back in time, we find that for most of the decade the EONIA displayed something like the heartbeat pattern, but it could have downward spikes as well as upward ones. Also, the EONIA baseline was not slightly above the deposit rate, but slightly above a different rate I call the repo rate and plot in orange. This rate is set by the ECB halfway between the deposit and marginal overnight rates. The repo rate didn't appear in the previous charts of overnight rates because it's a rate for weekly lending. The ECB mostly manages liquidity through it so-called "Main Refinancing Operations" (MRO) - the name implies that the ECB does intend to do most of the liquidity management through this channel. The MRO is a weekly auction of one-week liquidity in the form of repos, that is, collateralised loans. It is what the US Fed calls the discount window. This means that the ECB takes bids from banks for one-week loans for which the banks are required to post collateral (the same quality of "eligible collateral" behind the overnight Marginal Lending Facility). Normally interest rates for longer times are higher, so the fact that the ECB's daily lending is more expensive than its weekly lending is basically the ECB saying to banks "you can come to me for cash on Thursdays - on the rest of the week it's more expensive".
The "repo rate" baseline of EONIA did oscillate with the business cycle. To better illustrate the heartbeat pattern around it, JakeS suggested plotting the spread of interest rates with respect to the repo rate. It becomes more apparent how, towards the end of the series, the EONIA baseline drops from the repo rate to the deposit rate:
The current financial crisis kicked off in mid-2007, when the EONIA baseline becomes noticeably noisier than it was previously. Then, on October 15, 2008 (marked by a vertical line on the chart) the baseline drop from repo to deposit takes place. At that point the ECB switched its "Main Refinancing Operations" (MRO) from "variable rate, fixed tender" to "fixed rate, open tender". An opposite change took place on June 28, 2000 (also marked). Between both dates, the ECB was giving an upper bound to how much interest banks could bid to pay, and would allocate an amount of loans adding up to a given "fixed tender". Outside this time span, and in particular as a way to prevent a banking sector meltdown in the aftermath of the failure of Lehman Brothers, Dexia, Fortis, and Iceland, the ECB has been offering unlimited one-week liquidity (on eligible collateral) at a fixed rate.
The change from fixed tender at an auction rate to unlimited liquidity at a fixed rate in the MRO coincides with the start of a precipitous drop in the absolute level of the ECB's reference rates - perhaps overlaying both charts helps to visualize what's going on.
It can be seen that, simultaneously with the onset of unlimited liquidity, the baseline of interbank interest rates dropped below the ECB repo rate. During the steep drop of interest rates in late 2008-early 2009, each time the ECB lowered rates the EONIA dropped like a stone to some point between the new deposit and repo rates, whereas previously it would have stayed slightly above the repo rate. One month after the ECB lowered rates for the last time, EONIA settled into a heartbeat pattern just slightly above the 0.25% deposit rate.
Again, all through the Euro's history and up to the introduction of unlimited liquidity in late 2008, EONIA was around the repo rate, and has been just above the deposit rate since then. This has various implications. For instance, the Bundesbank explanation of minimum reserves quoted above is now incorrect in one minor point
credit institutions' holdings of required reserves are remunerated. The remuneration corresponds to the marginal rate (weighted according to the number of calendar days) of the main refinancing operations during the reserve maintenance period. This rate is therefore very close to the short-term money market rates.
Required reserves are remunerated at the MRO (repo) rate, which is now not
"very close to the short-term money market rates", since the latter have dropped to near the deposit rate.
Another implication is that banks are covering all their liquidity needs at the MRO rather than borrowing from each other at EONIA, which is strange given that EONIA is so much lower. This might mean that the amount actually offered at EONIA is relatively small, so while banks are receiving liquidity from the ECB they're actually hoarding it. A possible mechanism for EONIA to become decoupled form the MRO is a segmentation of the banking sector into (at least) two groups. One group of banks, the good old boys, are trusted by other banks and so borrow cheaply at EONIA (here's where we recall the observation that even under the heightened interbank volatility conditions of late the EONIA rate manages to touch back down near the deposit rate baseline some days - and remember also that EONIA is a weighted average of actual transactions). The banks other banks don't trust are financing themselves at the repo and marginal rates (that is, from the Central Bank, currently at 1% weekly and 1.75% daily, and on good collateral). The banks most everyone trusts are financing themselves at the repo and EONIA rates (1% weekly at the ECB on good collateral, and daily at the low rate they charge each other, without collateral). However, the volume available for EONIA lending among the trusted banks is dwindling because they are putting it in "sterilising" deposits at the ECB.
If the decoupling of EONIA and repo is indeed explained by a segmentation of the banking sector into "reputable" and "disreputable" banks with/without access to the interbank market, it's quite likely that another banking crisis is brewing in the Eurozone. The widening range and increasing volatility of EONIA does not bode well, and if this is indeed caused directly by the ECB withdrawing liquidity, the ECB's tight monetary policy cannot be described as anything less than reckless.