Chapter 4. Fragmentation, the Monetary Transmission Mechanism, and Monetary Policy in the Euro Area

Petya Koeva Brooks, and Mahmood Pradhan
Published Date:
October 2015
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Ali Al-Eyd and S. Pelin Berkmen 

The European Central Bank (ECB) has taken a range of actions to address bank funding problems, eliminate excessive risk in sovereign markets, and safeguard monetary transmission. As a result, the situation across the euro area financial system has improved since the summer of 2012; however, the degree of fragmentation remains high, with retail interest rates in stressed markets far higher than those in the core. These high rates have impeded the flow of credit and undermined the transmission of monetary policy. Analysis presented in this chapter indicates that the credit channel has been broken during the crisis, particularly in stressed markets, and that small and medium-sized enterprises (SMEs) in hard-hit economies appear to be most affected. Given these stresses, the ECB can undertake additional targeted policy measures, including through various forms of term funding, looser collateral policies, and direct asset purchases.

Has the Outright Monetary Transactions Program Delivered?

In mid-2012, the ECB announced the Outright Monetary Transactions (OMT) framework to address severe distortions in sovereign bond markets and to safeguard monetary transmission.

Since the announcement, excessive risk in stressed sovereign markets has been reduced and confidence in the euro restored. Spreads on Italian and Spanish government bonds have declined from unsustainable levels to those last seen in late 2010, before the deepening of the sovereign crisis. At the same time, market indicators suggest that euro redenomination risks have been taken off the table, if not completely eliminated (see Box 4.1).

Firms and banks have also benefited from the OMT announcement. Credit default swap (CDS) spreads for firms and banks in stressed economies have narrowed sharply in tandem with falling sovereign risks, leading to an improvement in bond issuance, particularly by firms. However, the impact on banks appears to be less pronounced, with issuance fading relative to the post–Long-Term Refinancing Operation (LTRO) period, and CDS spreads creeping up in 2013. In any event, both bank and corporate risks remain substantially below pre-OMT peaks.

Despite improved financial conditions, monetary transmission in stressed markets remains impaired.1 In particular, private interest rates—both deposit and lending rates—in these economies have increased relative to corresponding rates in the core and the ECB’s policy rates (Figure 4.1). This divergence began in 2011, and has since worsened, with Spanish and Italian firms in 2013 facing borrowing rates anywhere from 300 to 400 basis points higher than their counterparts in Germany.

Figure 4.1Euro Area Corporate Lending Rates


Source: European Central Bank.

Note: Unweighted average. Monetary financial institution lending to corporations valued under €1 million, one to five years’ maturity. Core = Belgium, France, Germany, the Netherlands. Stressed country = Greece, Ireland, Italy, Portugal, Spain. In the sample, Ireland is excluded from May 2011 and Greece from September 2012.

Box 4.1.Assessing Outright Monetary Transactions (OMT) and Redenomination Risks

The European Central Bank (ECB) introduced the OMT framework in response to “exceptionally high” risk premiums in sovereign bond markets related to fears of the reversibility of the euro.1 Sovereign yields in stressed countries have narrowed substantially, suggesting a decline in redenomination risk. However, isolating these risks from other market forces is difficult. In this regard, a few indicators can help shed light on the extent to which these risks have been removed. Two are considered here:

  • Speculative activity in euro currency contracts—In the wake of President Draghi’s “London Speech” in July 2012, the number of speculative short futures contracts in euros dropped markedly, reaching levels last seen before the crisis escalated in late 2010 (Figure 4.1.1). This drop was followed by a modest rise in long contracts. Although both contracts were volatile in 2013, and represent only a very limited slice of the overall euro currency market, they are often taken to be an indicator of broad market sentiment and tend to be well correlated with the euro exchange rate.1 The marked shift in positions thus suggests a distinct change in sentiment.
  • Legal jurisdiction of obligations—Similar bonds issued by the same large bank in a stressed country could be expected to trade somewhat differently if one (governed by local law) is considered to carry higher redenomination risk than the other (governed by international law). A rise in yields and widening of their relative spread could indicate the buildup of such risks, among others, before the London Speech. However, the ensuing improvement in their yields has been significant, and the stabilization of their spread largely sustained (beyond periods of broad market stress) (Figure 4.1.2).

Figure 4.1.1Euro Foreign Exchange Speculative Futures Contracts


Sources: Bloomberg, L.P.; and IMF staff calculations.

Note: Commitment of trade contracts in euro futures for noncommercial purposes.

Figure 4.1.2Bonds of a Stressed Country Bank: Local versus International Law


Sources: Bloomberg, L.P.; and IMF staff calculations.

Assessing the impact of OMT on euro redenomination risk is complex. However, notwithstanding this complexity, or the difficulty of disentangling factors driving market dynamics through the crisis, the indicators considered here display a marked shift in the period following the London Speech. A decline in speculative short euro currency positions and the improvement in the performance of stressed country bank (and sovereign) bonds is consistent with the decline, if not removal, of euro redenomination risks.

1 ECB Annual Report (2012).

Why Have Interest Rates Diverged?

The divergence in interest rates reflects the elevated fragmentation of financial markets. A combination of factors—including higher counterparty risks, regulatory hurdles (higher liquidity ratios and bail-in prospects), and the increased subsidiarization of banks’ business models (partly related to the rise of regulatory ring-fencing in some countries)—has undermined cross-border bank flows, particularly to the stressed countries, and contributed to diverging term funding costs with the core. At the same time, dampened growth prospects and, for certain countries, the prolonged period of low policy rates (with large mortgage books tied to the low Euro Interbank Offered Rate [Euribor]) have been weighing on banks’ profitability and capital positions, reinforcing the need to deleverage and derisk their balance sheets.

  • Cross-border banking flows have declined: Both core and stressed country banks have retrenched throughout the crisis, withdrawing capital to domestic markets and reducing their foreign lending. The departure of capital from the stressed countries is most pronounced, with core banks, including those in France and Germany, substantially reducing their exposure to these economies since the start of the crisis (amounting, for each of the French and German banks, to some 5—10 percent of GDP in Italy and Spain, and even higher in Ireland; see Figure 4.2).2 Most stressed country banks have also scaled back their lending to each other, while the volume of euro area unsecured interbank activity has declined by more than half.
  • Term funding costs have increased: The cost of unsecured bond issuance remains elevated for both core and stressed country banks, but there is a growing divergence between the two, driven mainly by rising spreads in stressed countries (Figure 4.3, second chart). The average spread (to benchmark rates) for stressed country banks at issuance was more than 430 basis points in March 2013, down only modestly from peak levels seen in early 2012, whereas that for core banks was about 180 basis points. Before the crisis, the spread between core and stressed country banks was negligible. Similar developments are evident in secured funding markets, with spreads on covered bond issuance in stressed countries rising throughout the crisis, even as banks have become more reliant on secured forms of borrowing.
  • Banks’ assets have become increasingly encumbered: This encumbrance reflects the shift toward secured funding, increased bank reliance on official liquidity facilities, and pressures from credit ratings downgrades on both private and public securities. However, secured funding costs have increased, further limiting banks’ ability to access this type of funding. Outside of the IMF program countries, encumbrance has increased markedly in Spain and Italy, and it has also increased in France, though the overall level is relatively low.
  • Pressures on banks’ balance sheets, including on profitability, have increased: Weak growth and high levels of private balance sheet debt in stressed countries are weighing on the health of bank balance sheets. Asset quality is declining, with nonperforming loans (NPLs) in Spain rising to 10.4 percent in February 2012 and those in Italy hitting 13.4 in December 2012.3 In addition, there are signs that bank profitability in both stressed countries and the core has been under pressure as firms and households deleverage. Net interest margins have moderated, while provisioning as a share of income has increased, notably for both Italian and Spanish banks (Figure 4.4) despite the support to profitability from increased holdings of own-sovereign debt, facilitated in particular by the three LTRO facilities. At the same time, pressures from the low policy rate environment can also weigh on banks’ profitability—for example, Spanish banks are unable to reprice large mortgage books tied to low Euribor rates.
  • Stressed country banks have increased their reliance on deposits: In particular, the spreads against Germany have increased substantially for term deposits (more than two years), reflecting the squeeze in term funding and further pressuring profitability.

Figure 4.2Change in Cross-Border Bank Holdings, 2008:Q1–2012:Q4

(Percent of counterparty country GDP)

Sources: Bank for International Settlements; and IMF staff calculations.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

Figure 4.3Euro Area: Financial Market Fragmentation

Sources: Bloomberg, L.P.; Dealogic; European Central Bank; Eurostat; Haver Analytics; and IMF staff calculations.

Note: bps = basis points; CDS = credit default swap; ECB = European Central Bank; OMT = Outright Monetary Transactions; SME = small and medium-sized enterprises. See Abbreviations section for composition of EU27.

1 Sovereign and bank CDS exclude Greece and are weighted by total debt.

2 Stressed countries = Italy, Ireland, Portugal, and Spain. The spread is that of stressed countries bank issuance costs over those of the core banks. The bonds are 1–10 years in tenor.

3 Banks are first averaged within own country, and then added across country groupings.

Figure 4.4Bank Provisioning and Lending Rates, 2009–2011


Sources: Bloomberg, L.P.; and IMF staff calculations.

Note: NFC = nonfinancial corporation. Data labels in the figure use International Organization for Standardization (ISO) country codes.

These risks and challenges are increasingly reflected in stressed country bank CDS spreads (Figure 4.5). After showing some improvement subsequent to OMT, spreads reached 430 basis points at the end of March 2013 (about 375 basis points higher than early 2008 levels). In fact, they have traded wider to those of core banks since the turn of 2013, following the turbulence in the wake of the Italian elections and events in Cyprus. This rise in spreads has coincided with lower bond issuances for both core and stressed country banks. At the same time, the relative volume of euro area corporate bond issuance has increased, pointing to a degree of disintermediation and unmet demand by banks for corporate borrowing.

Figure 4.5Spread between Core and Stressed Country Bank Credit Default Swaps

(Basis points)

Sources: Bloomberg, L.P.; and IMF staff calculations.

Note: Core = Austria, Belgium, France, Germany, the Netherlands.

Stressed countries = Greece, Ireland, Italy, Portugal, Spain.

Fragmentation Feeding into the Broken Monetary Transmission Mechanism

Together, pressures from fragmentation and weak balance sheets have contributed to elevated lending and deposit rates in stressed countries. A main consequence has been a breakdown in the monetary transmission mechanism in these economies (Annex 4.1). Despite lower policy rates, private interest rates remain high, reflecting a combination of factors, including lack of term funding for some banks, and weak bank and corporate balance sheets. As borrowing costs have risen, access to credit has been further reduced, particularly for SMEs, and Economic and Monetary Union deintegration forces have strengthened.

The European intermediation system is mainly bank based, with about 90 percent of nonfinancial corporation (NFC) debt financing intermediated through the banking sector (Figure 4.6). Although reliance on bond financing has been gradually increasing since the start of the crisis—because larger firms have turned to markets—it still remains low (about 11 percent).

Figure 4.6Euro Area: Nonfinancial Corporation Borrowing Breakdown


Source: European Central Bank.

Note: Core = Belgium, France, Germany. Stressed countries = Ireland, Italy, Portugal, Spain.

The interest rate channel has been hampered by the decline in interbank activity. As the volume of interbank activity declined through the crisis, so did the effectiveness of the transmission of policy rate changes to money market rates. A number of factors, including counterparty risks and the rise in excess system liquidity—partly reflecting supportive ECB measures and the general decline in economic activity, among others—have weighed on interbank activity, despite the reduced volatility of money market interest rates since early 2012.4

At the same time, weaknesses in both bank and corporate balance sheets undermined the credit channel. In addition to the decline in wholesale funding and rise in borrowing costs—forcing banks to deleverage, including by reducing their loan-to-deposit ratios through a combination of reduced assets and higher deposit rates—the stress in sovereign bond markets has also led to problems in the functioning of the monetary transmission mechanism. Government bonds not only serve as a benchmark (floor), but also are the prime source of collateral in the interbank markets, reinforcing the decline in activity there (Figure 4.7). Although the ECB’s unconventional policies have mainly aimed to restore this channel, the substitution of official funding for the missing market funding has caused lending rates to remain high since mid-2010, and overall credit growth is still subdued.

Figure 4.7Bank Lending to Interbank Market

(Percent change, year over year)

Sources: European Central Bank; and IMF staff calculations.

Note: Core = Belgium, France, Germany. Stressed countries = Ireland, Italy, Portugal, Spain.

The remaining obstacles for the proper functioning of the credit channel include (1) the lack of term funding in some stressed countries, with deposit rates and the cost of unsecured bond issuance remaining persistently high; (2) ongoing weaknesses in banks’ balances sheets—including from reduced profitability and declining asset quality in the low-growth environment—and the consequent strengthening of sovereign-bank links, given that banks have purchased sovereign debt with official liquidity (these factors limit credit supply); and (3) weak firm balance sheets, particularly in Italy, Portugal, and Spain, where corporate and household sector deleveraging is still ongoing (Bornhorst and Ruiz-Arranz 2013). While these headwinds limit credit demand, banks are also facing increasing NPLs and are unwilling to provide credit at the rates prevailing in the core European countries given reduced net worth and cash flow of NFCs and the decline in the creditworthiness of households.

Fragmentation and the broken monetary transmission mechanism affect SMEs disproportionately. Interest rates charged for small loans in stressed countries are higher than those charged for larger loans, but also higher than those charged for similar loans in core countries (Figure 4.3, panel 5). While the ECB’s bank lending survey indicates that demand for loans has been weak, its Survey on the Access to Finance of Enterprises shows that SMEs applying for loans are experiencing difficulties in obtaining credit from banks, particularly in Italy, Portugal, and Spain (Figure 4.8).5 SMEs listed “finding customers” and “access to finance” as their largest concerns. Although the availability of external financing (including bank loans, bank overdrafts, and trade credit) has improved in early 2013, as have the associated terms and conditions, the climate has been worse for SMEs than for larger companies (see Box 3 of ECB 2013).

Figure 4.8Outcome of Loan Application by EA Firms

(Average, April 2012–March 2013)

Source: European Central Bank Survey on the Access to Finance of Enterprises.

Note: SME = small and medium-sized enterprise. Among those firms that applied within the last six months.

Ensuring credit availability to viable SMEs is essential to supporting the recovery in the euro area, given that SMEs are about 80 percent of employment and 70 percent of value added in Italy, Portugal, and Spain (Figure 4.3, panel 6). In addition, the SME sectors in those three countries are dominated by micro-firms with fewer than 10 employees (about 94–95 percent of total firms).

Assessing the Pass-Through of ECB Policy Rates to Lending Rates

A simple model is used to assess the pass-through of policy rates to bank lending rates, controlling for factors capturing both the interest rate and credit channels. An error correction model is employed similar to those found in the ECB’s Monthly Bulletins of August 2009 and May 2010. The ECB focuses on quarterly interest rates at the euro area level, and explains various retail rates through money market rates, the capital-to-asset ratio, and credit risk. ECB (2010) concludes that credit risk was an important factor contributing to the widening of short-term lending spreads between 2008:Q3 and 2010:Q1. The study described here analyzes both euro area and country-level lending rates, covering France, Germany, Italy, Portugal, and Spain for January 2003 through February 2013. In particular, the changes in bank lending rates (ΔLRt) for small and large loans are regressed on simultaneous and lagged changes of market rates (ΔMRt), lagged changes of the bank interest rate, and on other measures of the credit channel, including bank funding, leverage, credit risk, and economic uncertainty (ΔXt). An error correction term is also included, to capture deviations from the long-term relationship. See equation (4.1).

Various specifications are examined to capture the range of effects on lending rates. Baseline regressions are run using monthly lending rates (on loans both less than and more than €1 million for all maturities), three-month Euribor, senior financial CDS to capture credit risk, bank bond spreads at issuance (for both stressed countries and core) to capture funding costs, asset-to-capital ratios to capture leverage, and Purchasing Managers Index to capture the overall economic outlook affecting firms’ balance sheets. Additional variables include lending rates to NFCs with maturities between one and five years, other money market rates (Euro OverNight Index Average [EONIA], three-month EONIA, three- and seven-year swap rates), other measures of credit risk (sovereign yields, subordinated financial CDS), other measures of cost of funding (bank equity prices, stock market indices, term deposit rates), other measures of leverage (loan-to-deposit ratio), and an economic policy uncertainty index to capture overall weak and uncertain economic activity.6 Baseline regressions are also run for the period 2003 through August 2008 to see how the pass-through changed after the crisis.7

The regression results support the notion that funding costs, credit risk, and leverage have become important determinants of lending rates since the onset of the crisis, particularly for stressed countries. These factors appear to be more relevant for small loans, such as are typically associated with SMEs.8 Detailed results are as follows:

  • Without controlling for other factors, the long-term pass-through from the Euribor to lending rates has declined since the crisis for the euro area as a whole and for stressed countries, but not for core countries (Figure 4.9). This outcome reflects the importance of other factors in determining lending rates in stressed countries.
  • Once other factors are controlled for, the long-term pass-through from the Euribor to lending rates is close to precrisis levels (Figure 4.10), implying that the postcrisis divergence in lending rates is explained by these other factors (cost of funding, credit risk, and leverage).
  • The immediate pass-through is broadly similar across countries, and larger for large loans (Figure 4.11).
  • Both the cost of funding and credit risk are significant factors in explaining lending rates for the euro area and the stressed countries, but not for the core countries. Similarly, assetto-capital ratios (capturing banks’ leverage) are significant for Italy and Spain, implying that banks with weak capital positions cannot (or do not) lower their lending rates. Broadly speaking, the long-term coefficients for the cost of funding, credit risk, and leverage are higher for small loans than for larger loans (except for Portugal, for which the coefficients are very close) (Figure 4.12).
  • The information in sovereign risk appears to be captured in financial sector risk and bank bond spreads (Figure 4.13). Although sovereign yields are significant when they are included in the regressions together with money market rates, they lose significance when the other cost-of-funding and risk variables are included in the regression. However, sovereign yields are significant in the term deposit rate regressions (particularly for Italy), possibly reflecting that banks and the sovereign are competing in the same funding market.
  • Although economic policy uncertainty and PMIs are significant in certain regressions, they lose their significance when other control variables are included. The significance of these variables could increase with additional data, reflecting the emergence of demand factors, as evidenced in survey data.
  • Term deposits appear to be an important factor for lending rates in Italy. The coefficient on the Euribor in the lending regressions is smaller because it also affects deposit rates.
  • Using alternative money market rates yields qualitatively similar results. Stock market indices (an alternative measure of the cost of funding) and the loan-to-deposit ratio (an alternative measure of leverage) are not robustly significant. The importance of the latter could be better captured in a panel regression framework (capturing countries with high dependence on wholesale funding), but homogeneity assumptions for other coefficients would be too restrictive. Regressions using lending rates for maturities of one to five years do not yield consistently significant results.9

Figure 4.9Interest Rate Pass-Through

(Long-term coefficients, not controlling for other factors)

Sources: Bloomberg, L.P.; European Central Bank; and IMF staff calculations.

Figure 4.10Long-Term Pass-Through

Sources: Bloomberg, L.P.; European Central Bank; and IMF staff calculations.

Figure 4.11Immediate Pass-Through

Sources: Bloomberg, L.P.; European Central Bank; and IMF staff calculations.

Figure 4.12Financial Credit Default Swap

(Long-term coefficient)

Sources: Bloomberg, L.P.; European Central Bank; and IMF staff calculations.

Figure 4.13Bank Bond Spreads

(Long-term coefficient)

Sources: Bloomberg, L.P.; European Central Bank; and IMF staff calculations.

Other studies have also found that credit risk, funding constraints, and weak firm balance sheets have affected the transmission mechanism during the crisis. Goretti (2013) examines the determinants of NFC lending rates in a panel regression framework. The paper regresses NFC lending rates on the Euribor, sovereign yields, and unemployment and finds that lending rates are determined more by sovereign yields and unemployment than by the Euribor after 2010. Ciccarelli, Maddaloni, and Peydro (2013) study the functioning of the credit channel to identify both bank lending and firm balance sheet channels using a panel vector autoregression framework, broadly differentiating the coefficients for stressed countries and others. The paper finds that the problems in the bank lending channel (caused by funding constraints) have been mitigated by the ECB’s unconventional monetary policy instruments, but that the transmission mechanism through the firm balance sheet channel remains impaired (as of end-2011) and appears more prevalent in small banks (which tend to lend primarily to SMEs). Zoli (2013) focuses on the Italian financial system and finds that sovereign spreads have transmitted to bank CDS spreads and bond yields, which were transmitted to firm lending rates. In addition, banks with lower capital ratios and higher NPLs were found to be more sensitive to sovereign spreads.

How Can the ECB Address the Broken Transmission Mechanism?

The ECB has deployed both conventional and unconventional policies to combat the crisis.10 Together, these actions have alleviated some funding problems for banks, reduced sovereign and private risk, removed tail risks related to the euro, and kept monetary conditions accommodative, particularly for the core countries. However, financial markets remained fragmented, and weak growth has reinforced balance sheet stresses and credit risks. These pressures have pushed up retail interest rates in stressed countries and restrained the flow of credit, undermining the transmission of monetary policy to stressed economies.

The evidence above highlights the importance of cleaning up bank balance sheets and implementing other measures to increase access to credit for SMEs. Repairing bank balance sheets and making further progress on banking union are essential to restoring confidence in the financial system, weakening bank-sovereign links, reducing fragmentation, and supporting credit and growth (see IMF 2013b). But because these actions will take time, it is important to stem the decline in real activity through various measures to support credit supply.

In this regard, the ECB should consider targeted policies to help reduce fragmentation and further improve monetary transmission. Monetary policy alone cannot address underlying weaknesses in banks’ balance sheets, but by supporting demand to the fullest extent, it can provide breathing space for this to occur. In most cases, policies would entail additional ECB balance sheet risks, but this alone should not inhibit further needed action. Such risks could either be addressed through offsetting measures, including a backstop provided by the European Investment Bank (EIB) (discussed later in this chapter), or sustained through gains to financial stability or the ECB’s ability to maintain a protracted investment horizon.

Ensure Term Funding Needs Are Met

At a minimum, the ECB should continue to support liquidity to weak banks. In line with the ECB’s current approach, this action could include (1) additional LTROs of considerable tenor (for example, three to five years) to ensure term funding for weak banks, and (2) a targeted review of existing collateral policies, including to lower haircuts on certain assets (for example, additional credit claims [ACCs] and asset-backed securities [ABS]). In combination, the result could be akin to credit easing. Although about a third of the three-year LTROs have been repaid, repayments have been largely driven by core banks with ample liquidity, and weaker banks in stressed countries remain reliant on official liquidity, given their high-term funding costs.

The provision of additional liquidity should at least cover any current funding shortfalls. As an example, based on 2013 loan-to-deposit ratios, the combined funding gap for Spanish and Italian banks is about €600 billion.11 Moreover, although the ECB’s full allotment policy ensures that there is sufficient liquidity in the system, the maturity of lending operations is limited to only three months, which is not conducive to term lending given the need to roll over frequently. It also prevents banks from matching new liabilities with existing longer-term assets, thus increasing incentives to deleverage. Therefore, additional LTROs of a scale similar to those already implemented could be useful, with additional amounts provided to promote further lending activity.

A targeted review of existing collateral policies is an integral part of this option, particularly given the pressures on system collateral and the encumbrance of banks’ balance sheets. Such a review would increase liquidity for weak banks and promote the flow of credit to SMEs without further broadening the pool of eligible collateral.

  • The ECB could reduce haircuts on certain assets, namely ACCs (linked to SME loans and ABS). This reduction would directly increase the availability of collateral for weaker banks and SMEs in stressed economies, and encourage greater securitization activity. Indeed, for a given collateral category, the ECB’s haircuts are larger than what is imposed by some other major central banks to limit risks to its balance sheet.12 At the same time, however, haircuts have become more binding as the quality of collateral has declined (see Box 4.2).
  • National central banks could be less conservative in assessing the quality of ACCs used as collateral and held on their balance sheets. National central banks may be too conservative in assessing credit risk—as a deviation from ECB criteria.13

Target Liquidity to SMEs

The ECB could also take actions to ensure that liquidity is directly targeted to SMEs. In particular, the ECB could consider a targeted lending scheme, similar to the U.K. Funding for Lending Scheme (see Box 4.3). Although LTROs together with relaxed collateral requirements function in a way similar to this program in providing funding for banks, they do not change incentives for banks to lend. Therefore, a new LTRO could be contingent on the provision of new lending to SMEs, directly supporting credit to this sector. For such an LTRO to prove effective, however, the costs to access the scheme must be less than alternative funding costs. Therefore, lower haircuts (as described above) should be considered in tandem.

Direct Private Asset Purchases

The ECB could circumvent weak banking systems through targeted asset purchases. Direct ECB purchases of private assets would support market-based credit to households and corporations while bank balance sheets are repaired. Program design could limit ECB balance sheet risks, though private assets could include securitized assets (supporting SME financing), corporate bonds, commercial paper (NFC financing), and covered bonds (bank funding), while mortgage-backed securities could be encouraged and accepted for collateral at Eurosystem liquidity facilities. Although the purchases could be small (to limit the balance sheet risks), official participation could boost confidence and thus act as a catalyst to further market activity. Depending on the nature of the program—that is, whether it targets existing loans—the impact could be timely, but may still be hampered by regulatory changes, including higher risk weights on securitized assets.

Box 4.2.Eurosystem Collateral

Throughout the crisis, the European Central Bank has drawn upon the flexibility of the Eurosystem’s collateral framework to provide increasing liquidity support to banks. Collateral policies have been relaxed on several occasions, including by broadening the base of eligible instruments to include additional credit claims and other nonmarketable assets.1 Along with the introduction of the three-year Long-Term Refinancing Operations (LTROs),2 the amounts of eligible collateral and average outstanding credit3 have increased substantially through the crisis (Figure 4.2.1).

Figure 4.2.1Collateral Pledged with the Eurosystem

(Billion euro)

Source: European Central Bank.

Despite these accommodative actions, however, there were signs of increased strains on system-wide collateral in 2013, particularly in stressed countries. Against higher unsecured funding costs, banks have become heavily reliant on secured borrowing, particularly through official facilities. The pressures on funding are evident at both the Eurosystem and private bank funding levels, and are transmitted through several channels.

  • The composition of pledged Eurosystem collateral has changed throughout the crisis, with a marked rise in the share of government securities and nonmarketable assets (about three-quarters of which are additional credit claims) and a drop in corporate and bank bonds. In addition, the pool of higher-quality government securities has decreased with ratings downgrades, and there has been a trend away from the use of cross-border assets toward domestic collateral, reflecting increased financial market fragmentation and regulatory “home bias.”
  • In addition, collateral in private funding markets appears increasingly encumbered for some. Apart from a few opportunistic periods following key euro area policy initiatives, the issuance of covered bonds and other asset-backed securities declined in 2012, while banks in stressed countries have seen a marked rise in associated bond spreads. In addition, the euro-denominated securitization market has declined by more than €250 billion to about €1 trillion since 2009, and the euro-denominated commercial paper market has dried up. Taken alongside the strains from official borrowing, the share of encumbered assets has increased during the crisis, notably for stressed economies (Figure 4.2.2).
  • Systemic factors are also contributing to strains on collateral. In particular, the move to central counterparty clearing systems for over-the-counter derivatives, and larger recourse to central bank liquidity (including through asset purchase programs by major central banks), add to the overall demand for high-quality collateral.

Figure 4.2.2Proportion of System Balance Sheets Encumbered

(Percent of banks’ assets)

Source: European Central Bank.

Note: ECB = European Central Bank; LTRO = long-term refinancing operation; MRO = main refinancing operations.

1 According to the European Central Bank, the eligibility of additional credit claims increased the collateral pool by approximately €600 billion to €700 billion, but this was only expected to result in about €200 billion of acceptable collateral because of stringent overcollateralization requirements.2 The ongoing repayment of three-year LTROs since the start of 2013 suggests that collateral will be released back into the system. However, the repayments also imply a reduction in excess system liquidity.3 Banks can and do prepledge collateral with the Eurosystem. Therefore, the rise in credit to collateral shown here is likely understated, suggesting more credit became available for the given pool of collateral.

Backstop from the EIB

The EIB could provide a backstop to contain the balance sheet risks. The EIB currently has paid-in capital of €55 billion (after a €10 billion increase). As an illustration, €10 billion provided as a backstop, or first-loss guarantee, to ECB private asset purchases could be leveraged to support a much larger pool of securitization activity. The amount of leverage would depend on several factors, including the amount of risk pooled among member states and the impact on EIB financial ratios.

Box 4.3.The Bank of England’s Funding for Lending Scheme (FLS)

The FLS was designed as a four-year collateral swap. Participating banks would place their lower-quality collateral with the Bank of England (with the usual haircuts and margins) in exchange for higher-quality gilts, which they could then use to obtain market funding at close to the policy rate. The initial FLS allowance was set at 5 percent of banks’ loan books, but the allowance increased pound-for-pound with net lending (that is, there was no ceiling on the scheme size). A built-in pricing incentive—an access fee that varied inversely with the volume of net credit extended—encouraged banks to lend (or minimize deleveraging).

Although the scheme has improved funding conditions, take-up has remained limited. The scheme has contributed to easing funding pressures on U.K. banks, with credit default swap spreads and deposit rates falling sharply since mid-2012. Some of this reduction has also translated into lower lending rates, particularly for mortgages. However, take-up of the scheme has been limited and banks have not made full use of the program, even to draw down up to 5 percent of their existing loans. Overall private sector lending has not picked up. But there was a net increase in lending if banks facing deleveraging pressures (Royal Bank of Scotland, Lloyds Banking Group, and Santander UK) are excluded, and FLS drawings contributed about two-thirds of that increase.

The program’s limited impact could be explained by the following factors:

  • Low cost advantage of accessing the scheme—Drawing down from the FLS conferred no big cost advantage. Banks face three costs: an access fee (25–150 basis points, depending on the bank’s net lending position), a Bank of England haircut on the collateral swapped to obtain the gilts, and the cost of market financing obtained using the gilts (essentially close to the policy rate). In 2013, these combined costs are not lower than what most banks would pay on wholesale or deposit funding raised directly, thus reducing the incentive to access the scheme. This lack of competitiveness with the market, however, could also reflect the scheme’s success in reducing banks’ funding costs.
  • Abundant liquidity and weak or low-quality demand for credit—With households deleveraging and bigger corporations able to borrow directly from markets at cheap rates, demand for bank credit is weak. Moreover, banks’ perceived credit risk, especially on lending to SMEs and unsecured credit to households, is likely to have been elevated, given weak aggregate demand and earnings prospects.
  • Health of U.K. banks—There were lingering concerns about the health of U.K. banks, especially their asset quality and the adequacy of existing capital buffers. As a result, despite being flush with liquidity, some banks have eschewed credit origination, persisting with previous deleveraging plans and using the cheaper funding to boost net interest margins instead.
  • Design of capital charge on FLS lending—The scheme initially allowed banks to offset under Pillar II the regulatory capital charge in respect of FLS-funded loans. However, the offset was done on the basis of average risk weight, which constituted a de facto incentive for banks to substitute increased secured lending but reduce SME lending. This is unlikely to be a significant factor, and the April 2013 modification to the FLS has addressed this by significantly improving the attractiveness of SME lending.
Note: See Annex 5 of IMF (2013a) for further details.

Nevertheless, even modest leverage could have a sizable impact on SME-backed securities. The euro area securitized bond market reached €1.03 trillion at end-2012, of which approximately €140 billion was collateral backed by SME loans (Figure 4.14). The current stock of SME loans by banks is estimated to be approximately €1.5 trillion. However, beyond SMEs, further support to market development could be achieved by including assets securitized by mortgages and by enhancing the commercial paper market infrastructure.

Figure 4.14Euro Area Securitized Bond Market as of End-2012

(Billion euro)

Source: Association for Financial Markets in Europe.

Note: ABS = asset-backed securities; RMBS = residential-mortgage-backed securities; SME = small and medium-sized enterprises. Euro area comprises Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal.

1Commercial-mortgage-backed securities; collateralized debt obligations; and whole business securitizations.

Annex 4.1. Monetary Policy Transmission Channels

Annex 4.1Monetary Policy Transmission Channels


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This chapter is based on “Fragmentation and Monetary Policy in the Euro Area,” IMF Working Paper 13/208, 2013.


Stressed countries refer to debtor countries that have experienced high funding costs (public and private) and suffered from financial fragmentation during the period covered.


According to the Bank for International Settlements’ statistics on banks’ consolidated international claims, ultimate risk basis.


Cross-country comparisons of NPLs are complicated by differences in definitions. For example, Italy’s impairment categories are broadly defined, capturing a wider class of impaired assets than in other countries.


As noted in ECB (2012), the decline in turnover of euro area money market instruments in the first half of 2012 was attributable to both the debt crisis—and the related impairment of the interbank market—and to the high excess liquidity environment that prevailed in the euro interbank market as a result of the two three-year LTROs conducted in December 2011 and February 2012.


Survey on the Access to Finance of Enterprises in the Euro Area (SAFE) (October 2012—March 2013). The survey covers about 7,500 firms, 93 percent of which are SMEs.


The Economic Policy Uncertainty Index is constructed from two types of underlying components (see PolicyUncertainty. com). One component quantifies newspaper coverage of policy-related economic uncertainty. A second component uses disagreement among economic forecasters as a proxy for uncertainty.


Because of the short sample period, the results are only indicative.


See Al-Eyd and Berkmen 2013 for further details.


During 2012, about 5 percent of new loans were in this category (8 percent for small loans and 3–4 percent for large loans). About 90 percent of the loans had maturities of less than one year.


In particular, policy interest rates have been lowered to historic levels, special liquidity facilities implemented, collateral policies relaxed, and OMT announced. In addition, the ECB and national central banks have made limited, direct interventions in selected securities markets through the Securities Markets Program and the Covered Bond Purchase Program.


This funding gap represents the difference between loans outstanding and deposits held, which is about €200 billion for Italy and €400 billion for Spain.


For example, the haircut imposed by the ECB on ABS (up to five-year tenor) is 16 percent, more than three times that imposed by the U.S. Federal Reserve on comparable assets.


In 2013, national central banks have the ability to accept ACCs that do not meet the ECB’s minimum eligibility criteria, but they must bear any associated risk on their own balance sheets. By setting their own criteria and risk-mitigation measures for ACCs—as “deviations” from those of the ECB (though approved by the ECB)—national central banks are able to ensure a greater provision of liquidity to weaker banks.

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