This Selected Issues paper on Euro Area Policies 2013 Article IV Consultation highlights the monetary transmission mechanism and monetary policies. The European Central Bank has announced the Outright Monetary Transactions framework to address severe distortions in sovereign bond markets and safeguard monetary transmission. The cost of unsecured bond issuance remains elevated for both core and periphery banks, but there is a growing divergence between the two, driven mainly by rising periphery spreads. Weak growth and high levels of private balance sheet debt in the periphery are weighing on the health of bank balance sheets.


This Selected Issues paper on Euro Area Policies 2013 Article IV Consultation highlights the monetary transmission mechanism and monetary policies. The European Central Bank has announced the Outright Monetary Transactions framework to address severe distortions in sovereign bond markets and safeguard monetary transmission. The cost of unsecured bond issuance remains elevated for both core and periphery banks, but there is a growing divergence between the two, driven mainly by rising periphery spreads. Weak growth and high levels of private balance sheet debt in the periphery are weighing on the health of bank balance sheets.

Fragmentation, the Monetary Transmission Mechanism, and Monetary Policy in the Euro Area1

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. But the degree of fragmentation remains high, with retail interest rates in stressed markets far above those in the core. This has impeded the flow of credit and undermined the transmission of monetary policy. Analysis presented here 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.

A. Has OMTs Delivered?

1. The ECB announced the Outright Monetary Transactions (OMTs) framework to address severe distortions in sovereign bond markets and safeguard monetary transmission.

2. 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, prior to 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 1).

3. Corporates and banks have also benefitted from the OMTs announcement. CDS spreads for corporate and banks in stressed economies have narrowed sharply in tandem with falling sovereign risks. This has led to an improvement in bond issuance, particularly among corporates. But 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 recent months. However, both bank and corporate risk remains substantially below pre-OMTs peaks.


Euro Area Corporate Lending Rates


Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001

Note: Unweighted average; MFI lending to corporations under €1 million, 1-5 years maturity. Core: Germany, France, Belgium, Netherlands.1/ Perpihery includes Greece, Ireland, Italy, Portugal, and Spain. In the sample, Ireland is excluded from May 2011 and Greece from September 2012.

4. But despite improved financial conditions, monetary transmission in the periphery and stressed markets remains impaired. 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. This divergence began in 2011, and has since become worse, with Spanish and Italian corporates currently facing borrowing rates anywhere from 300-400 basis points above their counterparts in Germany.

B. Why Have Interest Rates Diverged?

5. The divergence in interest rates reflects the elevated fragmentation of financial markets. A combination of factors—including elevated 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 periphery, 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 low Euribor rates) have been weighing on banks’ profitability and capital positions, reinforcing the need to deleverage and de-risk their balance sheets.

  • Cross border banking flows have declined. Both core and periphery banks have retrenched throughout the crisis, withdrawing capital to domestic markets and reducing their foreign lending. The departure of capital from the periphery is most pronounced, with core banks, including from 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 text figure).2 Most periphery banks have also scaled back their lending to each other, while the volume of euro area unsecured interbank activity has more than halved.

  • Term funding costs have increased. The cost of unsecured bond issuance remains elevated for both core and periphery banks, but there is a growing divergence between the two, driven mainly by rising periphery spreads (Panel 1). Indeed, the average spread (to benchmark rates) for periphery banks at issuance was over 430 basis points in March 2013, down only modestly from peak levels seen in early 2012, while that for core banks was around 180 basis points. Prior to the crisis, the spread between core and periphery banks was negligible. Similar developments are evident in secured funding markets, with spreads on periphery covered bond issuance rising throughout the crisis, even as banks have become more reliant on secured forms of borrowing.

  • Banks’ assets have become increasingly encumbered. This 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 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 the periphery are weighing on the health of bank balance sheets. Asset quality is declining, with nonperforming loans in Spain rising to 10.4 percent in February and those in Italy hitting 13.4 in December.3 In addition, there are signs that bank profitability in both the periphery and 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 (text figure). This comes 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 re-price large mortgage books tied to low Euribor rates.

  • Periphery banks have increased their reliance on deposits. In particular, the spreads over Germany have increased substantially for term deposits (over 2 years), reflecting the squeeze in term funding and adding further pressure to profitability.


Change in Cross-Border Bank Holdings, 2008Q-2012Q4

(in percent of Counterparty Country GDP)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001

Source: BIS; staff calculations
Panel 1.
Panel 1.

Euro Area: Financial Market Fragmentation

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001

Sources: ECB; Haver Analytics; Dealogic; Bloomberg; and IMF staff calculations.1/ Sovereign and bank CDS exclude Greece and are weighted by total debt.2/ Periphery is defined as Italy, Ireland, Portugal and Spain. The spread is that of periphery bank issuance costs over those of the core banks. The bonds are 1-10 year in tenor.Banks are first averaged within own country, and then added across country groupings.

Change in NFC Lending rate pre crisis avg. to 2012 (%)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001

Source: Bloomberg, staff calculations.*2009-11

6. These risks and challenges are increasingly reflected in periphery bank CDS spreads. After showing some improvement post OMTs, spreads reached 430 basis points at the end of March 2013 (about 375 basis points above early 2008 levels). In fact, they have traded wider to those of core banks since the turn of this year, 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 periphery 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.


Core vs. Periphery Bank CDS (bps)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001

1/ Core: AUT, FRA, DEU, NLD, BEL. PERIPHERY: GRC, IRE, ITA, PRT, ESP.Source: Bloomberg; staff calculations.

C. Fragmentation Feeding Into the Broken Monetary Transmission Mechanism

7. Together, pressures from fragmentation and weak balance sheets have contributed to elevated lending and deposit rates in the periphery. A main consequence has been a breakdown in the monetary transmission mechanism in these economies. Indeed, 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 deintegration forces in EMU have strengthened.

8. The European intermediation system is mainly bank-based, with about 90 percent of NFC debt financing intermediated through the banking sector (text chart). Although reliance on bond financing has been gradually increasing since the start of the crisis—as larger corporates have turned to markets—it still remains low (at about 11 percent).


Euro area: NFC borrowing breakdown


Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001

Source: ECB

9. 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 reduced volatility of money market interest rates since early 2012.4


Bank lending to interbank market (y/y)1/

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001

1/ Peirphery: ITA, IRE, PRT, ESP. Core: FRA, DEU, BEL., NLD.Source: ECB; staff calculations

10. At the same time, weaknesses in both bank and corporate balances 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. Indeed, 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. While the ECB’s unconventional policies have mainly addressed at restoring this channel, by substituting the lack of market funding with the official funding, lending rates remain high and overall credit growth is still subdued.

11. The remaining obstacles for the credit channel to properly function include: i) the lack of term-funding in some stressed countries, with deposit rates and the cost of unsecured bond issuance remaining persistently high; ii) ongoing weaknesses in banks’ balances sheets—including from reduced profitability and declining asset quality in low growth environment—and the consequent strengthening of sovereign bank links, as banks have purchased debt of their sovereign with official liquidity. These factors limit credit supply; and iii) weak firm balance sheets, particularly in countries such as Italy, Portugal, and Spain where corporate and household sector deleveraging is still ongoing (see 2013 SIP on indebtedness and deleveraging in the euro area). While these headwinds limit credit demand, banks are also facing increasing NPLs and are unwilling to provide credit at the rates that are prevalent in the core European countries given reduced net-worth and cash flow of NFCs and the decline in the creditworthiness of households.


Percent of Bank Loans Rejected

(ECB Safe survey, April 2012-March 2013, average)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001

12. Fragmentation and the broken monetary transmission mechanism impact small and medium enterprises (SMEs) disproportionately. Interest rates charged for small loans in stressed countries are higher than those charged for larger loans, but also than those charged for similar loans in core countries (Panel 1). While the ECB’s bank lending survey indicates that demand for loans has been weak, the SAFE survey shows that SMEs applying for loans are experiencing difficulties in obtaining credit from banks, particularly in Spain, Italy, and Portugal.5 SMEs listed “finding customers” and “access to finance” as their largest concerns. While there have been improvements in the availability of external financing (including bank loans, bank overdrafts, and trade credit) and in the associated terms and conditions during the last six months, the conditions have been worse for SMEs than for larger companies (see Box 3 of May 2013 ECB Monthly Bulletin).

13. Ensuring credit availability to viable SMEs is essential to supporting the recovery in the euro area, given that the SMEs are about 80 percent of employment and 70 percent of value added in Italy, Spain, and Portugal (Panel 1). In addition, SME sectors in Italy, Spain, and Portugal are dominated by micro-firms with less than 10 employees (about 94–95 percent of total firms).

D. Assessing the Pass-through of the ECB Policy Rates to Lending Rates

14. 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 creditchannels. 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 risks. The May 2010 note 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 individual country level lending rates, covering Germany, France, Italy, Spain, and Portugal for January 2003 to February 2013. In particular, the changes in bank lending rates (ΔLRt) for small and big 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 relation.


15. Various specifications are examined to capture the range of effects on lending rates. Baseline regressions are run using monthly lending rates (loans both below and over €1 million for all maturities), 3-month Euribor, senior financial CDS to capture credit risk, bank bond spreads at issuance (for both periphery and core) to capture funding costs, asset-to-capital ratios to capture leverage, and PMIs to capture overall economic outlook affecting firms’ balance sheet. Additional variables include lending rates to NFCs between 1-5 year maturity, other money market rates (overnight EONIA, 3-month EONIA, 3- and 7-year swap rates), other measures of credit risk (sovereign yields, subordinated financial CDS), other measures of cost of funding (bank equity prices, stock market indeces, 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 of 2003-August 2008 to see how the pass-through changed after the crisis.7

16. 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, typically associated with SMEs.8 Detailed results are as follows:

  • Without controlling for other factors, the long-term pass-through from Euribor to lending rates has declined after the crisis for the euro area (as a whole) and stressed countries, but not for core countries. This reflects the importance of other factors in determining lending rates in stressed countries.

  • Once controlled for other factors, the long-term pass-through from Euribor to lending rates is close to their pre-crisis levels, implying that the recent 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.

  • 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, asset-to-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, the long-run coefficients for the cost of funding, credit risk, and leverage are higher for small loans than for larger loans (except for Portugal, in which case the coefficients are very close).

  • The information in sovereign risk appears to be captured in financial sector risk and bank bond spreads. While 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. At the same time, sovereign yields are significant in the term deposit rate regressions (particularly for Italy), possibly reflecting that banks and sovereign are competing in the same funding market.

  • While 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 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 Euribor in the lending regressions is smaller as 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 captured better 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 1-5 year maturity do not yield consistently significant results.9


Interest rate pass-through

(LT coefficients, not controlling for other factors)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001


Immediate pass-through

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001


Long-term pass-through

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001


Bank bond spreads

(Long-term coefficient)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001


Financial CDS

(Long-term coefficient)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001

17. 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) looks at the determinants of NFC lending rates in a panel regression framework. The paper regresses NFC lending rates on Euribor, sovereign yields, and unemployment and finds that lending rates are determined more by sovereign yields and unemployment than the Euribor after 2010. A recent paper by Ciccarelli, et al. (2013) looks at the functioning of the credit channel, trying to identify both bank lending and firm balance sheet channels using a panel VAR framework, broadly differentiating the coefficients for stressed countries and others. The paper finds that the problems in the bank lending channel (due to 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). Finally, Zoli (2013) focuses on the Italian financial system and finds that sovereign spreads have transmitted to bank CDS spreads and bond yields, which was transmitted to firm lending rates. In addition, banks with lower capital ratios and higher NPLs were found to be more sensitive to sovereign spreads.

E. How Can the ECB Address the Broken Transmission Mechanism?

18. 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. But financial markets are increasingly fragmented, and weak growth has reinforced balance sheet stresses and credit risks. These pressures have pushed up retail interest rates in the periphery and restrained the flow of credit, undermining the transmission of monetary policy to stressed economies.

19. The evidence above highlights the importance of cleaning up bank balance sheets and other measures to increase access to credit for SMEs. Repairing bank balance sheets and making further progress on banking union are essential to restore confidence in the financial system, weaken bank-sovereign links, reduce fragmentation, and support credit and growth (see Staff Report). But, given that this will take time, it is important to stem the decline in real activity through various measures to support credit supply.

20. 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 EIB (discussed below), or sustained through gains to financial stability and/or the ECB’s ability to maintain a protracted investment horizon.

Assure term funding needs:

21. At a minimum, the ECB should take further action to support liquidity to weak banks. In line with the ECB’s current approach, this could include (1) additional LTROs of considerable tenor (e.g., 3-5 years) to ensure term funding for weak banks; and (2) a targeted review of existing collateral policies, including to lower haircuts on certain assets (e.g., additional credit claims (ACCs) and ABS). In combination, the result could be akin to credit easing. While about a third of the 3-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 high term-funding costs.

22. The provision of additional liquidity should at least cover any current funding shortfalls. As an example, based on current loan-to-deposit ratios, the combined funding gap for Spanish and Italian banks is about €600 billion.11 Moreover, while the ECB’s current full allotment policy ensures that there is enough liquidity in the system, the maturity of lending operations is limited to only 3 months. This is not conducive to term lending given the need to rollover frequently, and it also prevents banks from matching new liabilities with exiting longer term assets, thus increasing incentives to deleverage. In this context, additional LTROs of a scale similar to those already implemented could be useful, with additional amounts provided to promote further lending activity.

23. 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. This would increase liquidity for weak banks and promote the flow to credit to SMEs without further broadening the pool of eligible collateral.

  • The ECB could reduce haircuts on certain assets, namely additional credit claims (linked to SME loans and asset backed securities). This 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 But at the same time, haircuts have become more binding as the quality of collateral has declined (see Box 2).

  • National Central Banks could be less conservative in assessing the quality of ACCs used as collateral and held on their balance sheets. NCBs may be too conservative in assessing credit risk—as a deviation from ECB criteria.13

Target liquidity to SMEs:

24. 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 Funding for Lending Scheme in the U.K. (see Box 3). While LTROs together with relaxed collateral requirements function in a way similar to these programs 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. But for this to prove effective, 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:

25. 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—i.e., whether or not it targeted existing loans—the impact could be timely, but may still be hampered by regulatory changes, including higher risk weights on securitized assets.

Backstop from the EIB:

26. The EIB could provide a backstop to contain the balance sheet risks. The EIB currently has paid in capital of €65 billion (after a €10 billion increase that has nearly been completed). 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.

27. Nevertheless, even a modest leverage could have a sizeable 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. The current stock of SME loans by banks is estimated at approximately €1.5 trillion. However, beyond SMEs, further support to market development could be achieved by including assets securitized by mortgages, and enhancing the commercial paper market infrastructure.


Euro Area Securitized Bond Market as of end 2012

(€ billion)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001


Assessing OMTs and Redenomination Risks

The ECB introduced the OMTs framework in response to “exceptionally high” risk premia in sovereign bond markets “related to fears of the reversibility of the euro.” Periphery sovereign yields 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 to 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 euro dropped markedly, reaching levels last seen before the crisis escalated in late 2010. This was followed by a modest rise in long contracts. Although both contracts have recently been volatile, and represent only a very limited slice of the overall euro currency market, they are often taken as an indicator of broad market sentiment and tend to be well correlated with the euro exchange rate.1/ In this regard, the marked shift in positions suggests a distinct change in sentiment.

  • Legal jurisdiction of obligations. Similar bonds issued by the same (large) periphery bank could be expected to trade somewhat differently if one (governed by local law) is considered to carry higher redenomination risk to 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, prior to the London Speech. But the ensuing improvement in their yields has been significant, and the stabilization of their spread largely sustained (beyond periods of broad market stress).


Euro FX Specualitve Futures Contracts*


Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001

Source: Bloomberg; staff calculations*Commitement of Trade contracts in euro futures for non-commercial purposes.

Bonds of a Periphery Bank: Local vs. NY Law (percent)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001

Assessing the impact of OMTs on euro redenomination risk is complex. However, notwithstanding this, 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 speculaive short euro currency positions and the improvement in the performance of periphery bank (and sovereign) bonds is consistent with the delcine, if not removal, of euro redenomination risks.

1/ According to the ECB, Since the inception of the euro, the correlation between long contracts and the euro is 0.64, while that between short contracts and the euro is 0.42.

Eurosystem Collateral

Throughout the crisis, the ECB 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 non-marketable assets.1 Along with the introduction of the three-year LTROs2 the amounts of eligible collateral and average outstanding credit3 have increased substantially through the crisis.

However, despite these accommodative actions, there are signs of increased strains on system wide collateral, particularly in the periphery. Indeed, 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 transmit 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 non-marketable assets (about three quarters of which are additional credit claims) and a fall 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”.

  • At the same time, 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 the past year (Figure 6), while banks in the periphery have seen a marked rise in associated bond spreads. In addition, the euro-denominated securitization market has declined by over €250 billion to about €1 trillion since 2009, while 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.

  • There are also systemic factors contributing to strains on collateral. In particular, the move to central counterparty clearing systems for OTC 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.


Collateral Pledged with the Eurosystem (€bn)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001


Proportion of system balance sheets encumbered (percent of banks’ assets)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A001

1/ According to the ECB, the eligibility of additional claims increased the collateral pool by approximately €600-700 billion, but this was only expected to result in about €200 billion of acceptable collateral due to stringent overcollateralization requirements.2/ The ongoing repayment of three-year LTROs since the start of this year implies a release of collateral back into the system. However, this also implies a reduction in excess system liquidity.3/ Banks can and do pre-pledge collateral with the Eurosystem. Therefore, the rise in credit to collateral seen shown here is likely understated, suggesting more credit became available for the given pool of collateral.

Funding for Lending Scheme by the BoE 1/

The FLS was designed as a four-year collateral swap—participating banks placed their lower quality collateral with the BoE (with the usual haircuts and margins applied) 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 (i.e., there was no ceiling on the scheme size). A pricing incentive was built in to encourage banks to lend (or minimize deleveraging), via an access fee that varied inversely with the volume of net credit extended.

Although the scheme has improved funding conditions, take-up has remained limited. The scheme has contributed to easing funding pressures on UK banks, with CDS 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 one excludes banks facing deleveraging pressures (RBS, LBG and Santander UK), and FLS drawings contributed about two-thirds of that increase.

Limited impact could be explained by the following main factors.

  • Low cost advantage of accessing the scheme: There is not a big cost advantage right now to draw down from the FLS. Banks face three costs: an access fee (ranging 25bps to 150bps depending on banks’ net lending position), a BoE 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). At present, these combined costs are not lower than what most banks would pay on wholesale or deposit funding raised directly, reducing the incentive to access the scheme. This, however, could also reflect the scheme’s success in reducing banks’ funding costs.

  • Abundant liquidity and weak/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 UK banks: There are still lingering concerns about the health of UK banks, especially 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 Scheme has addressed this by significantly improving the attractiveness of SME lending.

1/ See Annex 5 of the U.K. 2013 Article IV Staff Report for further details.

Annex. Monetary Policy Transmission Channels


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Prepared by Ali Al-Eyd and S. Pelin Berkmen (EUR).


According to BIS statistics on banks’ consolidated international claims, ultimate risk basis.


Cross-country comparisons of NPL 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 is attributable to both the ongoing 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 small and medium-sized enterprises in the euro-area (SAFE) (October 2012-March 2013). The survey covers about 7500 firms of which 93 percent are SMEs.


The Economic Policy Uncertainty Index is constructed from two types of underlying components (see Baker, Bloom, and Davis: 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 forthcoming working paper for further details.


Over the last year, about 5 percent of the new loans were in this category (8 percent for small loans and 3-4 percent for large loans). About 90 percent of the loans has maturity less than 1 year.


In particular, policy interest rates have been lowered to historic levels, special liquidity facilities implemented, collateral policies relaxed, and OMTs announced. In addition, the ECB and NCBs have had limited, direct interventions in selected securities markets through the SMP and 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 5 year tenor) is 16 percent, more than three times that imposed by the US Federal Reserve on comparable assets.


At the present juncture, NCBs 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)—NCBs are able to ensure a greater provision of liquidity to weaker banks

Euro Area Policies: Selected Issues Paper
Author: International Monetary Fund. European Dept.