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ECB RESEARCH-Bond purchases, loose lending needed in combined crises

By Marc Jones

LONDON, Oct 2 (Reuters) - A new research paper by one of the key architects of the ECB's new bond buying plan has advocated the liberal use of bond purchases and giving banks easy access to cheap funding to fight a combined banking and sovereign debt crisis.

The study by the ECB's new head of market operations, Ulrich Bindseil, and Frankfurt academic Adalbert Winkler looked at 'dual liquidity' crises (financial and public debt) and ways different monetary regimes have reacted in the past.

The ECB adds a standard health warning to research papers that they do not necessary reflect the bank's view. Bindseil's new role, however, puts him at the centre of its current crisis planning and means he will oversee future bond buying.

Among other conclusions, the paper supported the more activist approach the ECB appears to have adopted with its new government bond buying-led crisis fighting strategy.

"The inability or refusal of the central bank to act as lender of last resort through outright purchases (of debt)increases the risk of a liquidity crisis because stabilizing efforts face additional constraints," the study said.

"Debt issuers have to rely on the domestic banking sector to perform this stabilizing function. This implies additional risks to financial stability, for example, because the banking sector may encounter capital limitations."

It also said a central bank without "a monetary financing prohibition" was "most flexible in containing a dual liquidity crisis."

Bindseil and Winkler's research added that even where commercial banks did continue to buy sovereign bonds, the central bank typically still provided much of the support because it lent banks the money with which to buy them.

That meant easy lending rules were also needed in times of crisis. "Borrowing limits of banks / credit constraints do not contain a liquidity crisis, but accelerate it by pushing all banks (potentially) affected by the limit into a state of fear from becoming illiquid," the study said.

A central bank "has to be in a position to adjust collateral constraints in order to enhance the elasticity of its liquidity provision and to limit bank defaults and a deepening of the crisis."

ON TARGET

In terms of lending the bank has long been practicing what the new research preaches. The bank has repeatedly slashed its lending standards over the last five years as the crisis has evolved to ensure strained euro zone banks are not unfairly starved of funding.

One of the consequences of this, however, is an increased dependency on ECB loans by Greek, Portuguese, Irish and many Spanish and Italian banks which has led to a huge build up of IOU's in the euro zone's financial plumbing system, known as TARGET2.

If the euro were to break up, Germany which is effectively the ECB's largest shareholder, could be left facing an enormous unpaid bill, something German policymakers have become increasingly vocal about over the last year.

Bindseil and Winkler used their paper to float various ways to reduce the imbalances once tensions subsided and prevent similar build ups in future.

The ideas centred on ways to charge banks more for ECB funding if they borrow above pre-set thresholds. It is likely to be a highly political topic in the euro zone where monetary policy is supposed to be one-size-fits all.

"For TARGET2 balances up to e.g. 25 percent of GDP, the normal MRO (main ECB interest rate) would apply, but then for each subsequent 25 percent, it would increase by say 0.5 percentage point."

"As the remuneration would be paid by the central bank, and hence be at the expense of the profits transferred to the Government, this would create economic incentives for the Government to address the reasons for the capital flight."

They also floated a slightly more complex plan to keep adding 0.5 percentage points of interest as borrowing went up. "A system of such surcharges would give the term "elastic currency provision" a more intuitive interpretation."

"Elastic" would mean that there is no hard limit but the more remote currency provision is from "equilibrium", the more some gradually increasing force (in the form of a financial incentive) emerges that pulls the system back to the equilibrium," the research said.

(for full research click ) (Reporting by Marc Jones)

((marc.jones@thomsonreuters.com)(+44)(0)(207 542 9033)(Reuters Messaging: marc.jones.thomsonreuters.com@reuters.net))