A. Main Principles and Institutional Design

3. The ECB/Eurosystem’s monetary policy objectives and high-level implementation framework are guided by the Treaty on the Functioning of the European Union (‘TFEU’) and the Statute of the European System of Central Banks and the ECB (‘ESCB Statute’). Article 127(1) of the TFEU establishes that the primary objective of the ESCB is to maintain price stability. Article 12.1 of the ESCB Statute charges the Governing Council with formulating monetary policy. The Executive Board implements such decisions, and to the extent deemed possible, the ECB has recourse to the national central banks to carry out operations which form part of the tasks of the ESCB.¹ The TFEU is less clear on the financial stability mandate of the ECB/Eurosystem compared to the mandate for monetary policy, but it is clear that the ECB/Eurosystem is expected to contribute to financial stability.² Since ELA is currently a responsibility of national central banks (NCBs), it is treated within the framework of Article 14.4 of the ESCB Statute.

4. In practice, monetary policy is decided centrally but is implemented on a decentralized basis. NCBs deal directly with their own counterparties (with regard to exercising tenders and collateral management) and local markets while the implementation framework and policy is determined by the Governing Council.³ The ESCB Statute provides that the Governing Council may decide that NCBs shall be indemnified in exceptional circumstances for specific losses arising from monetary policy operations.

5. The ECB/Eurosystem’s monetary policy implementation framework is intricate, reflecting the breadth of its counterparts and collateral specificities in member countries.⁴ Implementation of monetary policy is guided by a number of key ECB/Eurosystem principles, including neutrality and equal treatment (see Appendix I). The ECB/Eurosytem’s counterparty framework is broad, reflecting the breadth of the euro area (EA) banking system and the bank-based structure of lending to the EA economy. The calibration of the ECB/Eurosytem’s framework is underpinned by efforts to minimize disproportionate burdens on smaller banks. A Single List of collateral is common to all EA jurisdictions so that banks operating in different markets are not disadvantaged. The list covers both marketable and non-marketable assets that fulfil uniform EA-wide eligibility criteria. A positive ongoing development within the Eurosystem is the creation of a single collateral management system, which will provide a more efficient technical solution for collateral management services, and will contribute to the principle of equal treatment (of counterparties).

6. Pre-crisis, the ECB/Eurosystem successfully operated a conventional monetary policy implementation framework. Operating under a liquidity deficit environment, the ECB/Eurosystem’s approach was to inject liquidity at the margin through short-term repos (rather than outright purchases). The ECB/Eurosystem used its variable rate weekly operation as the main tool to provide liquidity to allow for the smooth fulfillment of banks’ reserve requirements over each reserve maintenance period. Longer-term repurchase operations (LTROs) of 3 months’ maturity—making up roughly 25 percent of the total liquidity provision back then—provided longer-term liquidity at market rates, aimed at smaller banks and those less sophisticated at liquidity forecasting. Overall, this system was very successful at stabilizing short-term rates (see Figure 1).

EONIA vs. ECB/Eurosystem Policy Corridor

(in millions EUR and in percent)

Citation: IMF Staff Country Reports 2018, 229; 10.5089/9781484369487.002.A001

Sources: Bloomberg, and IMF staff calculations.

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EONIA vs. ECB/Eurosystem Policy Corridor

(in millions EUR and in percent)

Citation: IMF Staff Country Reports 2018, 229; 10.5089/9781484369487.002.A001

Sources: Bloomberg, and IMF staff calculations.

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EONIA vs. ECB/Eurosystem Policy Corridor

(in millions EUR and in percent)

Citation: IMF Staff Country Reports 2018, 229; 10.5089/9781484369487.002.A001

Sources: Bloomberg, and IMF staff calculations.

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B. ECB/Eurosystem Non-Standard Measures in Response to Market Strains

7. The ECB/Eurosystem acted flexibly and decisively to address the unprecedented challenges brought about by the banking crisis and EA sovereign crisis.⁵ In addition to cuts in interest rates, the ECB/Eurosystem quickly modified its monetary policy implementation framework and used an exceptional set of non-standard policy tools. The ECB/Eurosystem significantly widened the scope of its operations by providing liquidity against a broader range of collateral and for maturities as long as four years and extended liquidity in foreign currency (FX). The ECB/Eurosystem through its non-standard measures mainly focused on banks, essentially intermediating in the banking system, to improve their funding and liquidity conditions. During and since the global financial crisis, the ECB/Eurosystem conducted large scale asset purchases (see Table 2 and Figure 2) and launched targeted lending operations in an attempt to repair the bank lending channel and to meet the ECB/Eurosystem’s price stability objective.⁶

ECB/Eurosystem Operations by Type

(in millions EUR)

Citation: IMF Staff Country Reports 2018, 229; 10.5089/9781484369487.002.A001

Sources: ECB, and IMF staff calculations.

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ECB/Eurosystem Operations by Type

(in millions EUR)

Citation: IMF Staff Country Reports 2018, 229; 10.5089/9781484369487.002.A001

Sources: ECB, and IMF staff calculations.

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ECB/Eurosystem Operations by Type

(in millions EUR)

Citation: IMF Staff Country Reports 2018, 229; 10.5089/9781484369487.002.A001

Sources: ECB, and IMF staff calculations.

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Table 2.

ECB/Eurosystem Asset Purchase Program

(end-January 2018; amortized cost; in euro million)¹

Source: ECB.

¹In terms of the ECB/Eurosystem’s terminated programs, as at January 2018, holdings under the Securities Market Program and covered bond purchase programs stood at EUR89,134 million and EUR10,775 million respectively (amortized cost).

Table 2.

ECB/Eurosystem Asset Purchase Program

(end-January 2018; amortized cost; in euro million)¹

	Total	Public Sector	Covered Bonds	Corporates	Asset Backed
Holdings	2,316,253	1,909,668	244,050	137,232	25,303
Risk Sharing	-	80 percent Not shared	Shared	Shared	Shared
WAM in years	Not available	7.65	Not available	Not available	Not available

Source: ECB.

¹In terms of the ECB/Eurosystem’s terminated programs, as at January 2018, holdings under the Securities Market Program and covered bond purchase programs stood at EUR89,134 million and EUR10,775 million respectively (amortized cost).

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Table 2.

ECB/Eurosystem Asset Purchase Program

(end-January 2018; amortized cost; in euro million)¹

	Total	Public Sector	Covered Bonds	Corporates	Asset Backed
Holdings	2,316,253	1,909,668	244,050	137,232	25,303
Risk Sharing	-	80 percent Not shared	Shared	Shared	Shared
WAM in years	Not available	7.65	Not available	Not available	Not available

Source: ECB.

¹In terms of the ECB/Eurosystem’s terminated programs, as at January 2018, holdings under the Securities Market Program and covered bond purchase programs stood at EUR89,134 million and EUR10,775 million respectively (amortized cost).

8. ECB/Eurosystem actions resulted in a structural shift in the liquidity position of the system to a position of excess, where the deposit facility rate became the relevant policy rate.

Furthermore, the main refinancing operation was no longer its primary operation, instead asset purchases and targeted longer-term refinancing operations became the main liquidity injection tools.

9. In order to underpin the banking system, the ECB/Eurosystem introduced some elements of positive discretion into its unified monetary policy implementation framework.

These discretionary derogations which may apply to very specific cases (see Appendix III) allow certain banks to continue to access ECB/Eurosystem standard operations.

10. Constraints placed on the ECB/Eurosystem meant that sometimes its actions were effective in addressing its primary concerns but might have been sub-optimal in supporting monetary and capital markets union.⁷ Unlike under a national system, the ECB/Eurosystem does not have a central fiscal backstop.⁸ So, when expanding its collateral framework, for example, the expansion bore some resemblance to the principles of its older (pre-2007) Tier 1/Tier 2 collateral framework by allowing NCBs to determine the eligibility criteria and accept the related credit risks of this collateral within certain limits set centrally by the Governing Council. More recently the ECB/Eurosystem has conducted the majority of its asset purchases on this non-loss sharing basis.⁹ Furthermore, as discussed later, the ECB/Eurosystem introduced significant improvements to its securities lending arrangements.¹⁰ The ECB recognizes that its actions have resulted in an increasingly complex framework, and it is understood that work is underway to seek opportunities for streamlining.

A. Main Principles and Institutional Design¹¹

11. The provision of ELA is currently a national responsibility, and its use in recent years was a key instrument for stabilizing the system. The provision of ELA within the EA is a discretionary decision for the relevant NCB(s). ELA losses, should they occur, reside with the NCB that provided the ELA.

12. Where significant ELA amounts are disbursed, this is subject to non-objection by the Governing Council. Specifically, where ELA for an individual financial institution or a given group of financial institutions exceeds a threshold of EUR2 billion, the Executive Board shall decide whether Governing Council consideration is required. In such circumstances the Governing Council assesses whether the provision of ELA interferes with the objectives and tasks of the ESCB (Article 14.4 of the ESCB Statute). All NCB actions, including the provision of ELA, are assessed by the ECB/Eurosystem from a monetary financing perspective.¹²

13. The provision of ELA is not an itemized item in NCB or ECB balance sheet publications. ECB/Eurosystem rules do not require NCBs to publish balance sheets on a regular basis, but the ECB/Eurosystem does set guidance which the ECB/Eurosystem recommends applying to national operations “to the extent possible” for consistency and comparability reasons.¹³ In practice, NCB’s publish their balance sheets on a monthly basis, while the ECB itself publishes a consolidated balance sheet statement on a weekly basis, in addition to a daily estimate of the net liquidity effect from autonomous factors and monetary policy portfolios.¹⁴

14. In 2017, the ECB/Eurosystem took the positive step of moving towards a more transparent ELA framework. Before this little detail around the structure or provision of this arrangement was available publicly; mainly in order to prevent moral hazard and to incentivize self-insurance of liquidity risks. However, the increasing need for ELA by certain banks and banking systems during the crisis, and the increasing number of information requests received by the ECB/Eurosystem, prompted the ECB/Eurosystem to re-consider its approach and resulted in publishing the ELA Agreement with a view to streamlining and increasing transparency around the framework for central bank liquidity support to financial institutions.¹⁵

15. The ELA Agreement includes a description of the allocation of responsibilities, costs, and risks for euro denominated ELA, and for the provision and sharing of information. Many features of the ELA Agreement are structured as guidance to NCBs, given the national responsibilities around ELA use; for example, central banks are encouraged to put in place cooperation arrangements with other central banks, but are not required to do so. The ELA Agreement specifies certain key criteria (e.g. required solvency metrics) and other requirements, such as the need for funding plans within two months of when ELA is first provided. Some ELA features, such as the rate to be charged for foreign exchange ELA, and details regarding acceptable ELA collateral, are not disclosed.

16. Solvency is determined by compliance with harmonized minimum regulatory capital levels, while a formal viability assessment is not applied.¹⁶ Credit institutions falling short of capital requirements can potentially receive ELA subject to an adequate recapitalization plan.¹⁷ Meanwhile, should collateral allow, and conditional on counterparty eligibility criteria and related requirements being fulfilled, banks in the process of a swift and credible recapitalization, can continue to access ECB/Eurosystem monetary policy operations, but without any other ELA safeguards or government indemnities in place. Liquidity is potentially available to support resolution actions, except liquidation. Since July 2017, monetary policy liquidity is no longer provided to entities in wind-down, except for a narrowly defined grandfathering of legacy entities. ELA support to entities in wind-down is not explicitly referred to in the ELA Agreement.¹⁸

17. Decisions around the need for supporting indemnities from fiscal authorities resides with NCBs, but reliance on indemnities is complicated by European Union (EU) state aid rules. State indemnities are rarely sought by NCBs because they trigger the application of state aid rules. EU state aid rules apply where credit risk associated with ELA operations is moved from the central bank to the state.¹⁹ The IMF mission was informed that such an EU assessment would not necessarily delay or prevent the timely provision of ELA, as in general, the EU assessment commences only after the European Commission is notified of the provision of the government indemnity. However, the assessment could add uncertainty to ELA provision, and therefore risk undermining the policy objectives the operation is trying to achieve. Uncertainty is created, inter alia, by the fact that the European Commission’s 2013 Banking Communication is (i) silent on the conditions that a state guarantee for ELA should meet to be deemed compatible with the TFEU, and (ii) does not detail what remedial actions need to be taken should state aid be considered to be incompatible with the TFEU.

18. There are a number of emergency lending facilities available to support the euro and FX liquidity needs of euro area CCPs, but the configurations are complex. CCPs with banking licenses (of which there are two) have the potential to be counterparts under the ECB/Eurosystem’s standard framework, including access to the ECB/Eurosystem’s marginal lending facility and the U.S. dollar swap facility. In 2010, the possibility of providing euro area CCPs with access to marginal lending facility at the discretion of the Governing Council was introduced into the TARGET2 Guideline. FX needs from nonbank EA CCPs may be considered under NCB ELA arrangements at national risk. Regarding CCPs domiciled outside of the euro area, the ECB/Eurosystem may establish liquidity arrangements in line with the announcement of the international central banks.²⁰ In accordance with this announcement, a dedicated arrangement was put in place by the ECB/Eurosystem and the Bank of England (BoE). The scope of the existing BoE- ECB/Eurosystem FX swap arrangement was extended to cover potential emergency liquidity provision in euro to certain U.K. CCPs.²¹ Should the swap line be activated for the relevant U.K. CCP(s), the credit risk of the CCP(s) would not be borne by the ECB/Eurosystem since they would be lending to the BoE.

19. ELA has been used by some banks for extended periods. Despite the broad expansion of eligible collateral for ECB/Eurosystem monetary policy operations, there were reported instances where banks had to take recourse to ELA arrangements, sometimes for prolonged periods in the absence of full market access.

20. Within the ECB, the anticipation and monitoring of liquidity needs is strictly bound by a “separation principle.” There is a formalized framework for the exchange of liquidity-related data between the supervisory and monetary policy implementation and risk management areas of the ECB, both in the regular course of business and in emergency times.²² In general, ECB Banking Supervision incorporates information received from the monetary policy implementation side of the ECB into their own prudential liquidity templates, while information received from ECB Banking Supervision is used by the monetary policy implementation and risk management side of the ECB to support relevant assessments (e.g., continuous financial soundness of monetary policy counterparties). This information sharing does not extend to recovery plans. The agreement is data focused and stops short of encouraging collaboration and the free and open flow of information between supervisory and operational/risk management teams.

21. At a national level, different approaches are taken regarding supervisory and monetary policy implementation/risk management interactions. The ECB/Eurosystem does not set minimum requirements regarding information sharing arrangements within NCBs or between National Competent Authority (NCAs) and NCBs, and therefore different approaches are taken regarding the information that is gathered and how this information is shared across monetary policy implementation/risk management and supervisory areas.

22. ECB monitoring of the liquidity needs of CCPs focuses primarily on an assessment of data and outputs from supervisory colleges established under European Market Infrastructure Regulation.²³ Additional and more real-time liquidity information may be obtained by the ECB’s monetary policy operations area by relying on NCBs to request such information from national competent authorities (NCA) of EA CCPs.²⁴ In contrast, based on the dedicated BoE- ECB/Eurosystem emergency liquidity arrangement for relevant U.K. CCPs, the ECB/Eurosystem with the BoE has operationalized direct information exchanges for both regular and crisis-management purposes.

A. Money Markets

23. The EA’s money markets, while being deep and liquid, have been heavily influenced by the post crisis regulatory environment. In Europe, the main money market segment is the very short-term money market (most of which is an overnight market), including both unsecured, and secured transactions. The unsecured call market was, in the pre-crisis environment, the principal interbank market, but volumes have been declining in recent years mainly due to the high levels of excess liquidity, a preference shift towards collateralized transactions and more favorable regulatory treatment of secured trades. In addition, ECB/Eurosystem policy actions, such as the introduction of the TLTRO, appear to have squeezed out some use of both short-term and term funding markets.

24. ECB/Eurosystem monetary policy operations, asset purchases and the resulting excess liquidity environment as well as regulatory developments, have contributed to greater demand for, and lesser supply of, certain collateral for secured repos. Although secured market volumes have been sustained, cash driven transactions have declined significantly since the introduction of the APP. The demand for HQLA stemming from regulatory constraints, combined with ECB/Eurosystem asset purchases, has contributed to a clear (often jurisdiction-based) price differentiation in the EA secured market, with general collateral markets often trading below the ECB/Eurosystem’s deposit facility (currently minus 40 basis points), and with specials trading below those levels (Figure 3).²⁵

General Collateral Rates

(in percentage)

Citation: IMF Staff Country Reports 2018, 229; 10.5089/9781484369487.002.A001

Sources: Bloomberg, and IMF staff.

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General Collateral Rates

(in percentage)

Citation: IMF Staff Country Reports 2018, 229; 10.5089/9781484369487.002.A001

Sources: Bloomberg, and IMF staff.

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General Collateral Rates

(in percentage)

Citation: IMF Staff Country Reports 2018, 229; 10.5089/9781484369487.002.A001

Sources: Bloomberg, and IMF staff.

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25. Regulatory measures aimed at addressing the buildup of leverage and unstable funding models have also had a material impact on functioning of repo markets. ECB staff analysis has found that correlations between adjustments in the NSFR and the LCR don’t appear to be significant for repo activity. But in response to higher leverage ratios, banks may have somewhat reduced their repo activity, particularly over end-reporting periods.²⁶ The reduced intermediation capacity by banks over regulatory reporting dates (so-called ‘window dressing’), globally, not just in the EA, appears to be adding to market volatility. These pressures have been compounded by higher CCP margin requirements and the lower availability of those assets held in the ECB/Eurosystem monetary policy portfolios.²⁷ Strains became pronounced at end-2016; at the time there continued to be a market, though not a cheap one.

26. In response, the ECB/Eurosystem took decisive action to ensure that its monetary policy actions did not impair market functioning or the smooth transmission of monetary policy signals. While the ECB/Eurosystem’s asset purchases have increased excess liquidity, they have also squeezed collateral markets and in response to these market pressures, in early 2017 the ECB/Eurosystem removed the deposit facility rate floor on eligible purchases, thereby increasing the spectrum of potential purchases. The ECB/Eurosystem also set and published guidance for NCBs regarding securities lending arrangements, including permitting the acceptance of cash collateral, subject to an overall limit. ²⁸ The ECB/Eurosystem monitors the market and its securities lending activities closely so as to ensure the ongoing effectiveness of the arrangements.

27. Overall, it appears that markets are adapting, but some strains are likely to recur. Helped by the ECB/Eurosystem measures, the spreads of the repo market rates to the ECB deposit facility has narrowed, and there has been increased pre-funding by market participants, since early 2017. But strains are likely to continue particularly given that year-end balance sheets form the basis for the calculation of regulatory metrics, including the leverage ratio, contributions to the Single Resolution Fund (SRF), global systemically important bank (G-SIB) designation and categorization related charges, as well as bank (tax) levies.

28. The ECB/Eurosystem has taken a strong role in supporting market reforms of systemically important reference rates (see Appendix IV). The ECB/Eurosystem is fully aware of the pivotal role of reference interest rates and is actively supporting industry reforms. The ECB/Eurosystem is developing its own alternative overnight reference rate, and recognizes the importance of transition measures, which will be crucial, particularly for longer-term rates given their widespread use in financial contracts. The ECB/Eurosystem will not be creating term reference rates as there are not enough transactions to construct a purely transactions-based index. This implies that expert judgement may be required. Such judgement cannot come from a central bank as it might be interpreted as being related to the (desired) monetary policy stance and accordingly might create, or be perceived as creating, a conflict of interest.

B. Foreign Currency Markets

29. The euro is the world’s second most traded currency. The EA has an active FX market with a wide range of instruments. Table 3 below summarizes the general structure of the EA FX market.²⁹ FX swaps dominate, with spot being the next most traded instrument ahead of outright forwards.

Table 3.

Euro Area: Foreign Exchange Market Size and Composition

(as at April 2016, USD billions)

Source: Bank for International Settlements Triennial FX Turnover Survey, April 2016.

Table 3.

Euro Area: Foreign Exchange Market Size and Composition

(as at April 2016, USD billions)

	Daily Turnover	Percent Total
Spot	519.3	33.1
Outright Forward	177.5	11.3
FX Swaps	807.1	51.5
Options	64.3	4.1
Total	1568.2	100.0

Source: Bank for International Settlements Triennial FX Turnover Survey, April 2016.

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Table 3.

Euro Area: Foreign Exchange Market Size and Composition

(as at April 2016, USD billions)

	Daily Turnover	Percent Total
Spot	519.3	33.1
Outright Forward	177.5	11.3
FX Swaps	807.1	51.5
Options	64.3	4.1
Total	1568.2	100.0

Source: Bank for International Settlements Triennial FX Turnover Survey, April 2016.

30. Some banks in the Eurosystem have a structural mismatch between their U.S. dollar assets and liabilities, which requires routine funding in the market. In part, this may reflect investors being pushed abroad as a result of ECB/Eurosystem asset purchases. As part of coordinated international swap lines, the ECB/Eurosystem has had in place a U.S. dollar swap facility, which provided an effective backstop to European banks that had U.S. dollar funding needs during the global financial crisis (GFC). In November 2011, pricing was reduced from Overnight Index Swaps (OIS) plus 100 to OIS plus 50 regardless of maturity, in an attempt to de-stigmatize the facility. As liquidity conditions improved, in January 2014, the ECB/Eurosystem removed its 84-day operation from its framework, providing instead mainly one-week U.S. dollar liquidity.³⁰

31. While in general there is ample market liquidity in U.S. dollars, pressures sometimes build and the FX basis has become pronounced around regulatory and balance sheet reporting dates. Banks have weathered some shocks in the past few years—such as reforms to the U.S. money market mutual funds (which in 2016 saw a decline in asset holdings of prime funds and therefore the demand for short-term paper declined). But U.S. G-SIB designation and categorization charges meant that pressures in dollar funding markets continued to occur around regulatory reporting dates in 2017.

32. These pressures have resulted in occasional increased recourse to the ECB/Eurosystem’s U.S. dollar swap facilities, particularly over regulatory reporting dates, although total usage is relatively small (Figure 4). At end-2017 drawings from the ECB/Eurosystem’s U.S. dollar swap facility reached close to US$12 billion. It is difficult to exactly pinpoint the driver of structural demand for U.S. dollars, but there is anecdotal evidence that there are real money demands from bank’s customers who have increased their holdings of U.S. dollar assets due to the monetary policy divergence between the Fed and the other major central banks.

U.S. Dollar Swap Facility Drawings and Price Differentials

(in billions USD and percentage points)

Citation: IMF Staff Country Reports 2018, 229; 10.5089/9781484369487.002.A001

Sources: ECB, Bloomberg, and IMF staff.

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U.S. Dollar Swap Facility Drawings and Price Differentials

(in billions USD and percentage points)

Citation: IMF Staff Country Reports 2018, 229; 10.5089/9781484369487.002.A001

Sources: ECB, Bloomberg, and IMF staff.

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U.S. Dollar Swap Facility Drawings and Price Differentials

(in billions USD and percentage points)

Citation: IMF Staff Country Reports 2018, 229; 10.5089/9781484369487.002.A001

Sources: ECB, Bloomberg, and IMF staff.

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A. Framework Issues

34. The ECB/Eurosystem and the European authorities generally should seek to clarify what the ECB’s financial stability mandate is, so that the ECB/Eurosystem can have confidence when conducting operations for financial stability purposes and be held accountable. So far, market support measures have been linked to the smooth transmission of monetary policy, which may limit the ECB/Eurosystem’s potential responses to a financial crisis. The actual market-wide operations implemented by the ECB/Eurosystem were generally effective for reducing the strains identified, but the options might have been broader, and the operational choices easier, if the ECB/Eurosystem’s financial stability mandate had been clearer. For example, there may have been options to use small scale market making operations rather than large scale purchases. A clarification of the mandate would also have wider benefits, such as reducing the scope for legal challenge that has been raised in respect of some of the ECB/Eurosystem’s operations since the crisis.³¹ A clearer financial stability mandate would ideally be supported by explicit recognition of the attendant powers and the governance arrangements through which they would be exercised.

35. The size of the ECB/Eurosystem’s steady state balance sheet will depend on the demand for its liabilities, which have been boosted by liquidity regulations. Factors such as the leverage ratio, LCR, NSFR, and margin requirements for central clearing have boosted the demand for HQLA, including ECB reserve balances. The ECB/Eurosystem will need to decide how much of that structural demand to meet, consistent with its monetary objectives, and ensure that it has the scope to increase liquidity further in a crisis. It seems likely that the ECB/Eurosystem’s asset purchases will be allowed to run off rather than being sold. ³² Either way, a floor approach to setting interest rates seems likely to remain until the balance sheet has reached its long-run level. In normal times, monetary policy operations should incentivize banks to build HQLA stocks in the market, rather than relying on using non-HQLA in ECB/Eurosystem monetary policy operations. One way to do this is through adjustment of the ECB/Eurosystem’s collateral framework, notwithstanding the necessary risk management protections already in place.

36. Recognition should be given to the wider role of collateral policy, beyond one of pure central bank credit risk management. A positive example of this is where the ECB/Eurosystem has used asset backed securities (ABS) eligibility criteria to try and improve consistency and transparency around ABS transactions in the market.³³ While the ECB/Eurosystem’s risk control framework equalizes credit risks across different collateral groups, the framework may not necessarily provide sufficient incentives to market participants to mobilize different types of collateral. This becomes more relevant given the increased demand for central banks to take on a collateral transformation role following recent regulatory reforms. The ECB/Eurosystem’s collateral policy should seek to avoid undue incentives, otherwise market participants may become more vulnerable as (i) it will be more attractive for banks to hold the least liquid eligible collateral and minimize their holdings of more costly liquid assets and (ii) they may thus become reliant on the ECB/Eurosystem’s collateral transformation role to meet their regulatory metrics, rather than on markets, even in normal times. Arguably through current arrangements the ECB/Eurosystem could be seen as providing a subsidy to the markets for less liquid assets, and the outcome could be counter to the intention of the new liquidity regulations, which aim at encouraging banks to internalize the cost of liquidity.

37. The introduction of differential charges for less liquid collateral would be a useful way for the ECB/Eurosystem to incentivize banks to build HQLA buffers in the market and should be investigated further (Box 1). There are various potential methods for setting differential charges, including the use of interest rate add-ons—at a spread above the policy rate—or separate collateral auctions, which could provide a better means of differentiating the value of liquidity associated with non-marketable collateral, particularly when banks are unlikely to be loan book collateral constrained.³⁴ We note that, whatever operational design is chosen, care does need to be taken so that the monetary policy signal is not distorted by the differential charges (which would be determined by collateral characteristics rather than monetary policy goals). Consideration could also be given to disclosing key features of the operations, such as the “clearing spread” which could give a good indication of what the market is prepared to pay for this privileged central bank support and allow the market to better prepare their bids.

38. The current ECB/Eurosystem framework has been effective in responding to market strains, but a more comprehensive, forward-looking and harmonized framework would be helpful in supporting the monetary, banking and capital markets unions. The ECB/Eurosystem’s current framework is an accumulation of decisions made during a prolonged period of market stress. As market conditions normalize, it will be important to embed a framework that supports progress towards euro area -wide capital markets. For example, changes to securities lending arrangements were necessary and effective to alleviate strains brought about by ECB/Eurosystem purchases, but operations are still conducted on a different basis in each jurisdiction.³⁵ The ECB’s view is that the current set-up strikes a good balance between harmonization and adjustment to local market conditions, but the market’s perceptions are that arrangements fall short of a more market efficient centralized system. Harmonizing securities lending arrangements would further support euro area-wide market functioning, and help align EA risk free rates which would be positive for the smooth transmission of monetary policy.³⁶ Similarly, the re-introduction of non-loss sharing arrangements for ECB/Eurosystem repurchase operations goes against the positive step taken through the creation of the Single List of collateral.

39. There should be a clearer separation between monetary policy operations and ELA. In particular, the ability to request a derogation to use self-issued government guaranteed bank bonds as collateral in ECB/Eurosystem monetary policy operations on a case-by-case basis, when general collateral buffers have been exhausted, is surrogate ELA, or could even delay necessary resolution actions, while it also introduces a level of opaqueness between ECB/Eurosystem monetary policy operations and ELA. Instead an ELA framework should provide full safeguards and incentives for managing such collateral constrained institutions.

B. Transition Issues

40. The ECB/Eurosystem needs to give careful signals to the market as it exits away from crisis related policy measures. At the moment, the market has a clear interpretation of what it thinks the ECB/Eurosystem will do—i.e. net purchases to stop towards end-2018, and moving away from negative interest rates at least six months later, with re-investments continuing over a longer period—although that interpretation seems credible, should events require a deviation, this could result in some volatility in markets.

41. Experience from the United States suggests it would be helpful, once thinking has progressed sufficiently, for the ECB/Eurosystem to prepare and publish balance sheet normalization principles.³⁷ High-level normalization principles would help market participants understand the ECB/Eurosystem’s intentions. Dealing with normalization would benefit from advance planning, including increased transparency around the maturity of asset purchases so if a decision is taken to run-off these assets, such actions can be priced into markets. Normalization principles would help market participants understand the ECB/Eurosystem’s intentions, and should be supported by a clear and consistent communication policy to minimize risks of policy misinterpretation and market disruption.

42. One particular risk is the potential “cliff-edge” risks associated with the ECB/Eurosystem’s TLTROs. TLTROs begin to mature in mid-2020, and therefore part of the funding begins to fall below 12-month maturity (relevant for regulatory compliance) from mid-2019. It is likely that banks will begin in earnest to replace TLTRO funding from late-2018. Possibly, longer-term funding markets may become abruptly “crowded”, with smaller banks with limited or no market access being potentially more vulnerable. Although voluntary TLTRO repayments are permitted, they are not required, so the ECB/Eurosystem will need to monitor the outstanding amounts and consider whether further intervention is needed in order to smooth out the exit from these operations. The implications for term funding occur well before the maturity of the operations themselves, as the term of the operations declines below those required to meet regulatory term-funding metrics. Policy options could involve interim lending operations at market rates, rather than at preferential lending rates.

C. Other Issues

43. More generally, the ECB/Eurosystem may have cause to intervene to deal with market dysfunction. Support to securities markets is a nascent topic and because of this, can bring an element of unease within central banking circles. Even so, in recent years some central banks have deemed it necessary to support the functioning of securities markets with the aim of ensuring continued credit flow, mitigating the risks of financial asset fire sales, and supporting the transmission of monetary policy.³⁸ The ECB/Eurosystem’s large-scale asset programs (e.g., the first and second covered bond purchase programs, and securities market purchase program) have had the effect of supporting certain securities markets, but were designed to effect a monetary expansion. Alternative small-scale buy-sell operations could in some circumstances be as supportive, without the attendant monetary expansion. It would be useful if the ECB/Eurosystem—supported by a clarification of the ECB/Eurosystem’s financial stability mandate, as recommended by the FSAP—were to design principles for such operations so that in the future, if the ECB/Eurosystem did decide that this was an appropriate action, responses could be mobilized in a timely fashion with less operational risk and consider if, without implying a pre-commitment, whether elements of this discussion should be disclosed to the market.³⁹

44. The ability to support securities markets may become more relevant given a possible build-up of liquidity risks in the nonbank sector. Recent ECB financial stability reviews have highlighted that liquidity and maturity transformation is growing among bond funds, driven by less-liquid portfolios and lower cash holdings resulting in smaller buffers against large outflows. Whilst it is not generally appropriate for nonbanks to receive ELA, it may be a case that certain systemically important markets need to be supported in order, for example, to prevent fire sale dynamics with possible systemic consequences. This possibility does not mean that all markets should be supported: interventions should be a truly last-resort action (no pre-commitment), and targeted at markets that are normally liquid, systemically important, and of high credit quality. Sometimes a statement of commitment might be sufficient.

45. The U.S. dollar swap line proved to be an extremely important tool for the ECB/Eurosystem in managing the systemic demand for U.S. dollar liquidity, but its operational parameters could be reviewed and its objectives clarified. On the one hand, it might be better if firms had to fund their FX needs in the market in steady state, but in the near-term, the factors that affected the EUR/USD basis in 2017 do not appear to be completely transient. The ECB/Eurosystem’s U.S. dollar facility might therefore need to be retained for the foreseeable future. While the ECB/Eurosystem has reduced the term of this arrangement, pricing policy should also be reviewed to prevent opportunities for simple arbitrage outside stressed periods.⁴⁰ This could, for example, take the form of auctions of fixed quantities, rather than full allotment at a fixed price, with quantities perhaps increased around year-end. Any changes in the structure and the operational parameters of the facility would need to be discussed and agreed with other central banks among the swap network. Messaging around the arrangement should also be clarified, because the facility appears to be stigmatized, at least by a number of market participants, which could limit its effectiveness in stressed conditions.

46. As part of this work, careful attention is also needed to quantify the likely factors affecting U.S. dollar supply going forward. Specifically, U.S. monetary policy normalization and fiscal plans, including repatriation of offshore cash, could drain the supply of U.S. dollars in the future. Meanwhile, U.S. authorities are in the process of setting funding requirements above the minimum standards required by the Basel III liquidity framework. That may increase foreign banks’ need to hold U.S. dollar liquidity in the United States. Quantifying these elements would give the ECB/Eurosystem a broad estimate of potential recourse to the arrangement going forward.

47. More generally, market volatility related to the end-period regulatory and balance sheet reporting could be reduced by the EA adopting averaging reporting periods for the leverage ratio and SRF contributions. The demand for funding, by quantity, maturity, currency and market source is being heavily influenced by regulatory demands. Average-period reporting of liquidity metrics and other requirements could help as the pressures appear to be cumulative. Moreover, the policy intentions of the leverage ratio would be better met by such a change. At the same time, no single change is likely to eliminate end-period issues, unless, or until, all such frictions are recognized and addressed in all major currency markets.

48. The ECB/Eurosystem is fully aware of the pivotal role of reference interest rates and is actively supporting industry reforms. The ECB/Eurosystem is developing its own alternative ECB/Eurosystem overnight rate, and recognizes the importance of early developed transition measures, which will be crucial for longer-term rates given their widespread use in financial contracts. A key challenge will also be to ensure the responsiveness of short-term rates to changes in policy rates. A smooth transition to new reference rates, especially the novation of existing long-term assets, such as the possible replacement of Euribor, is not yet assured and could lead to significant market stresses.

49. Consideration should also be given to how the liquidity management practices of CCPs are influenced by access to ECB/Eurosystem deposit facilities. It seems reasonable that the ECB/Eurosystem should give CCPs access to a safe asset, but it is important not to take away the incentive for CCPs to undertake proper liquidity management. An assessment should take place as to the potential for CCPs to dis-intermediate the banking system by relying on the ECB/Eurosystem’s deposit facility for liquidity management purposes. This may be especially relevant in cases when the CCP unexpectedly needs to collect large amount of funds (e.g. variation margin (VM)) and those funds are not passed on to the market (i.e. directly to clearing members and their clients as VM payouts or via investments with the market), but held by the CCP with the central banks. Depending on the flexibility that the banks may still have at hand over the remaining part of the reserve maintenance period, they may face some challenges with their liquidity management due to the sudden increase of CCPs’ overnight cash balances held with the central bank. The ECB/Eurosystem could consider tools to minimize the impact of such cases, such as through the introduction of remuneration limits.⁴¹ Such tools should also encompass an ability for the ECB/Eurosystem to be able to receive information from NCAs or directly from the CCPs themselves, to facilitate timely “horizon scanning” and to assess the factors driving deposits in stress situations. This analysis would also be helpful in analyzing flows to determine the remuneration tiers, for example.

A. ELA Framework

51. Looking forward, the FSAP sees significant benefits to further harmonizing and ultimately centralizing ELA arrangements. There are a number of reasons that call for ELA decisions and risk to be assumed at the supranational level, rather than by NCBs, including (i) progress towards the banking union and continuing financial integration, (ii) the fact that the ECB is the competent authority for supervising all (significant) banks, and (iii) the reputational risk and complexity with preparing multiple cross border swap lines and collateral arrangements. Consistent with banking union developments, the ECB is now in a better position to take an objective view as to whether, and for how long, a bank should receive ELA, which would avoid any risk of misalignment of objectives when ELA is being provided. Under a more centralized approach, ELA decision making responsibilities (rather than just the ability to non-object) would reside with Governing Council, but the mechanics of ELA provision could be conducted on a decentralized basis (similar to the approach taken to current monetary policy implementation). Moreover, to achieve greater harmonization and ultimate centralization on a sound basis, the ECB/Eurosystem will need to clarify several issues, including: (i) its financial stability mandate underpinning centralized ELA, (ii) governance arrangements including profit distribution and allocation of losses, ⁴² (iii) standardizing ECB/Eurosystem’s monetary policy collateral framework across member countries, and (iv) building “horizon scanning” capacity to centrally anticipate and manage ELA needs.

B. “Horizon Scanning” Arrangements

52. “Horizon scanning” involves looking for potential liquidity and other risks before they materialize, thereby allowing for advanced preparations. This process involves the sharing of knowledge and views on markets and institutions within a formalized framework, which would be facilitated by having a shared watch-list. Discussions could be based around items such as liability and asset flows and scenario analyses, perceptions of the institutions from daily interactions, asset encumbrance levels, and collateral issues.

53. Information exchange within the ECB seems to be data driven and formalized engagement arrangements do not seem to be fully effective. The separation principle may be restricting the ability of both supervisory and monetary policy implementation/risk management areas to expand and improve joint “horizon scanning” so as to be able to enhance the ability to anticipate and therefore manage liquidity stresses. While there may be tensions, for example in knowing that an ECB/Eurosystem counterparty may be facing prudential difficulties, failing to share full information and views in both directions would not alleviate this issue. Rather it could just delay correct actions being taken. Knowledge that one of the ECB/Eurosystem’s counterparties was having prudential issues or liquidity pressures, should not automatically lead to an entity having limited access to ECB/Eurosystem operations purely on risk grounds. Rather, a joint decision needs to be taken at a senior level about the best way to manage the entity under stress reflecting broader policy objectives. Countries with recent experiences of ELA have tended to move to closer collaboration internally, in order to fully exploit informational advantages and take account of different views. Closer collaboration could be encouraged through some further formal mechanisms, such as jointly preparing ELA funding plans (incorporating jointly agreed (stress) analyses of flows in the assets and liabilities of the entity) earlier (i.e., closer to when the ELA is given rather than within the current two-month timeline), and developing a shared watch list for banks and CCPs (under a “horizon scanning” framework). For this enhanced framework to work at a national level, similar and harmonized arrangements should also apply.

54. Supervisory actions should start before buffers are exhausted and even before ELA is deemed necessary. Evidence that an entity’s buffers are deteriorating, should be taken as a strong signal of deficiencies in liquidity management by the bank in question, which deserve supervisory attention and, typically, timely corrective action, and providers of ELA should be alerted through the joint watch list.⁴³ Once a bank has reached the stage of ELA, then the supervisors and providers of ELA need to work hand in hand in order to help restore the bank’s liquidity position and strengthen its liquidity management.

55. Harmonized ELA collateral pre-verification processes should be developed as a complementing exercise. This process involves pre-identifying and pre-checking by the relevant NCB—from an operational and legal perspective—the eligibility of portfolios of assets well in advance of ELA drawdown. This can and should be done without encumbering the collateral. This would help ensure that all eligibility requirements are met and that the collateral is available, when and if required by the counterparty in question; it would be particularly useful for credit claims. In other jurisdictions this process is known as “pre-positioning” of collateral. Pre-positioning of collateral could bring a number of benefits to the ELA process, for example, it would allow the respective NCB to determine which collateral is available to be quickly mobilized with the respective NCB, should ELA needs arise, and for which collateral further due diligence is required before mobilization; it would reduce the delay between an ELA application and the actual drawdown of the liquidity, and would also help all relevant stakeholders understand the entity’s survival time should ELA need to be relied upon.

C. Detailed Arrangements

56. Until ELA is centralized, the ECB/Eurosystem should ensure that all intra-EA and external ELA co-operation agreements are formalized. While the provision of ELA remains a national responsibility, this should not prevent the ECB/Eurosystem ensuring that ex-ante cooperation and home host relations (including cross-border collateral arrangements) are formalized so that responses are timely and coordinated. However, for this to work effectively, more clarity in respect of the ECB/Eurosystem’s financial stability mandate would be helpful.

57. The ECB should take a coordinating role in testing of ELA arrangements. There are benefits in conducting ELA testing in terms of operational preparedness. The ECB is best placed to coordinate, especially for cross-border institutions over which it has a more comprehensive view.

58. Meeting FX needs in ELA remains an unresolved problem for the global central banking community; nevertheless, the ECB/Eurosystem should be coordinating arrangements

as far as it is able across the EA. While the existing ECB/Eurosystem swap lines are potentially available, these are intended to deal with dysfunction in foreign currency markets and their use is dependent on international agreement. However, neither the NCBs nor the ECB can be expected to hold the very large FX cash buffers that would be commensurate with possible ELA needs for a large institution. Nor could FX-denominated securities portfolios be easily mobilized to generate large volumes of FX cash quickly, even should the vires permit the use of FX reserves in that way. That leaves two means by which potentially large FX exposures can be managed. The first is to take action to limit FX liquidity mismatches where possible, for example by imposing an LCR in each significant currency. In addition, advance agreement could be sought internationally on the conditions for the possible use of swap lines for ELA.⁴⁴

59. The FSAP sees benefits in the ECB/Eurosystem clarifying the role of liquidity provision in relation to banks affected by resolution measures.⁴⁵ A bank emerging from resolution that is experiencing liquidity strains could have access to ECB/Eurosystem monetary policy operations. If not, for example if it did not have enough eligible collateral, it would need to seek ELA. Preparations for resolution measures must take into account the availability of collateral and the constraints on central bank refinancing (e.g., that use of ECB/Eurosystem monetary policy operations requires eligible collateral and that ELA is discretionary). It is important to clarify expectations across all relevant EA stakeholders in line with applicable legal frameworks. A resolution strategy would benefit from early engagement between all concerned authorities (e.g., ECB, Single Resolution Board), in order to ensure that the access to the ECB/Eurosystem’s monetary policy framework and ELA, along with required safeguards, boundaries of support, and to discuss scenarios where collateral for ECB/Eurosystem monetary policy operations or ELA may not be immediately available.⁴⁶ Mutual understanding in this area would benefit from an MOU. The intervention strategy and planning must respect these constraints.

60. Current ELA eligibility criteria should be enhanced by incorporating forward looking viability and solvency assessments of the entity. With recent enhancements to other parts of the safety net structure, an explicit forward-looking assessment would clarify that ELA has no role in meeting the liquidity needs of entities in “wind-down.” Moreover, a more explicit and forward business model assessment would help ensure that an institution is likely to remain viable, which would help set clear boundaries around the role of ECB/Eurosystem liquidity support. For a bank that is using its capital buffers, there is no need to wait for the formal data to show that it has become undercapitalized, these forward-looking solvency and viability assessments should be started in anticipation.

61. Consideration should be given to paring back or at least streamlining state aid oversight for state indemnities provided to support ELA provision. In an emergency situation such as a bank resolution, the speedy provision of liquidity is of the essence. Yet in such a situation, and in particular in the context of bank resolution, the NCB may have doubts such as about (i) the quality of the counterparty (e.g., solvency is not clear); (ii) the collateral presented by the institution; (iii) the size or length of support; or (iv) the exit strategy. In such circumstances, a state indemnity to the relevant NCB may be necessary to enable ELA to be provided. The Commission should consider implementation rules whereby such indemnities are presumed to be compatible with EU state aid rules and possibly exempted from notification, when state involvement and distortion of competition are both limited and certain safeguards are met. For example, these situations could include instances where a bank does not need any financial support other than time-bound state-guaranteed ELA, where a bank is fully bailed-in by private investors, or where the resolution of a bank involves it being split and sold in the market according to fair and open procedures. Safeguards for such an approach should be in place. They could include; (i) validation by the NCB/ECB/Eurosystem of 2013 Banking Communication requirements of ‘solvency’, ‘exceptional’, ‘penal interest rate’, and ‘temporary liquidity needs’ (all of which are assessed by the EA as part of its ELA provision process), and (ii) ‘viability’ being introduced as an explicit ELA criterion as recommended by this FSAP.

D. Other Issues

62. The ECB/Eurosystem’s approach to EA CCPs should be refined to remove apparent inconsistencies. Euro area CCPs at the discretion of the Governing Council may access euro liquidity through the possibility introduced into the TARGET2 Guideline. FX emergency support (beyond the U.S. dollar swap facility available to ECB/Eurosystem counterparts) is at national risk. The FSAP takes the view that any euro or FX emergency liquidity support from the Eurosystem should be formalized within a centralized framework, especially for EA CCPs, which are inherently deeply engaged in cross-border activities. The FX resources would need to be identified, particularly as current ECB FX reserves are for intervention purposes only.⁴⁷ While the possibility established under the TARGET2 Guideline provides a euro safety net for EA CCPs, this facility should have the safeguards equivalent to an ELA framework applicable to financial institutions (e.g., increased supervisory intrusion, funding plans and possibly reporting obligations, which normally apply to any ELA provision).

63. For (emergency) liquidity support to CCPs to operate effectively, information gathering would need to be improved. Discussions are currently ongoing within the EU regarding a stronger role for the ECB/Eurosystem as central bank of issue with regard to CCPs, and such developments could help the ECB/Eurosystem to directly receive timely information on CCPs and allow it to respond in a timely fashion should circumstances warrant.

64. Financial stability considerations justify flexibility in both the content and timing of the disclosure of information relating to ELA provision. A central bank is justified in temporarily keeping ELA information out of the market, to protect systemic financial stability, while providing full transparency ex post when its release would no longer undermine stability. Some recent national EA FSAPs have identified that ELA operations could be inferred and amounts estimated from the NCB’s monthly balance sheets. Some central banks, for example the Federal Reserve and the Bank of England, have taken steps to ensure that ELA operations cannot be identified through routine balance sheet reporting, and ELA only becomes known with a lag. The Eurosystem should examine the ability to disclose their full balance sheets with a lag only.⁴⁸ If legal requirements would oblige banks to disclose their recourse to central bank facilities, then disclosure waivers should apply.⁴⁹