The European Central Bank

The European Central Bank Closing the dustbin lid Aug 28th 2008 From The Economist print edition Banks will soon find it a bit harder to game the euro-zone’s liquidity support NO ONE could accuse the European Central Bank (ECB) of taking its lead from America. While policymakers there contemplate the salvation of Fannie Mae and Freddie Mac, the troubled government-sponsored mortgage firms, the ECB is set to tighten up its rules to ensure that what it offers to banks is strictly liquidity support, and nothing more. A change to the rules that govern its money-market operations could be agreed on by the bank at its next rate-setting meeting on September 3rd and 4th. If so, it will mark a minor reversal in a global trend. As the credit crunch has intensified, central banks have relaxed the conditions for supplying ready cash to commercial banks. The Federal Reserve has made loans available for longer, and to more banks, to provide some security of funding. The Bank of England has temporarily widened the range of securities it accepts to include less pukka bonds, such as asset-backed securities (ABS). Jean-Claude Trichet, the ECB’s chief, has been able to boast that, unlike these central banks, the ECB has not had to change its lending policy. But there is growing concern that the ECB’s liberality is being abused. A worry is that banks in countries where housing busts have made investors wary of mortgage-backed assets have created securities for the express purpose of gaining central-bank funding. This practice may be exposing central banks to too much credit risk, as well as stalling the recovery of the market for mortgage-backed assets. There are signs of an increased dependence on ECB funding in some markets. The supply of central-bank cash in Ireland and Spain has more than doubled in the past year, both in size and as a share of the euro-area total (see chart). Ireland’s huge share is bloated by lending to non-Irish banks located in Dublin. Fitch, a credit-rating agency, said in May that standards for newly minted mortgage-backed securities in Spain had slipped since the credit crunch started. Despite this, such securities are appraised at close to their face value. Because trading in ABS is so limited, there is no reliable market benchmark. Another concern is that affiliates of foreign banks are using the ECB as a source of funds for lending outside the euro area. Macquarie, a Sydney-based investment bank (see article), was recently able to secure an ECB loan through a euro-area affiliate, putting up a security backed by Australian car loans. The ECB has been discussing for several months how to tighten the rules to prevent such abuses, without disrupting its cash lifeline to banks. One idea is to increase the “haircuts” it subtracts from the market value of collateral, in order to protect against a decline in asset prices (the bigger the haircut, the smaller the amount that can be borrowed). Haircuts vary from less than 1% for the safest and most liquid government bonds to 18% for some long-dated asset-backed securities. Increasing the haircuts for some securities would offer extra protection against the risk that initial valuations of collateral are too generous. When accepting collateral, the ECB could also restrict or ban the use of some securities that seem to have been created primarily to take advantage of central-bank funding. One tactic would be to rule that only a small fraction of any ABS or corporate-bond issue could be permissible. A severe haircut on newly created securities that have not been traded in private markets may be considered too. The ECB could insist that collateral is backed by income streams in euros, which would curb banks from using its funds to finance loans made outside the euro area. Yves Mersch, head of Luxembourg’s central bank and a member of the ECB’s governing council, said at the weekend that any adjustments to the bank’s collateral policy would amount to fine-tuning. The bank is unlikely to want to disrupt the flow of liquidity by making big changes. The ECB’s main concern should be to shield its constituent central banks from the risk of loss if a bank defaults, and to ensure that banks are not shifting their credit risk onto the ECB on favourable terms. That would amount to a subsidy to those banks putting up poor-quality collateral. Protecting central-bank capital is especially important in the euro area, which has no central fiscal authority. If a multinational bank collapsed and defaulted on its loans from the central bank, making good on any losses on the collateral would be a messy business.