Draghi assures us, not quite yet

Dysfunctional government bond markets in several euro area countries hamper the single monetary policy because the way this policy is transmitted to the real economy depends also on the conditions of the bond markets in the various countries. An impaired transmission mechanism for monetary policy has a damaging impact on the availability and price of credit to firms and households.

This is the very important monetary policy reason for the ECB’s non-standard measures. But of course, such interventions can only be limited. Governments must – individually and collectively – restore their credibility vis-à-vis financial markets.

Tensions in sovereign bond markets have been accompanied by stress in the banking sector given the financial interlinkages between governments and banks. The ECB has taken several measures in 2010 and 2011 to ensure that banks continue to have access to funding sources. This has enabled them to continue lending to firms and households.

See Izabella Kamniska for some of the important details.

Let me give you the briefest of rundowns from a American Fed-centric perspective. Though this is all still hazy in my own mind.

In normal times banks lend overnight money to each other without demanding any collateral. This market is the crux of the financial system. In the US its called the Fed Funds market. In Eurozone, EONIA.

Monetary policy usually revolves around managing this market. However, in stressful times this market can breakdown. This is problem number one.

However, things still workout because a variety of repo markets are still working to provide liquidity. These markets, however, require collateral. This is usually government bonds.

However, when collateral is falling rapidly in value the private repo market can begin to shut down.

Luckily you have the Central Bank repo market, where you can always go and get funds. That is, if you have collateral. So, now you face a situation where individual banks might need to borrow collateral in order to take it to the central bank.

Here in lies the major shut down. If people will not let you borrow collateral, because they distrust that you will give it back, etc, then you may not have anything to take to the central bank. If you don’t have anything to take to the central bank, you can’t get Euros.

As this possibility sets in both the interest rate on borrowing collateral and the amount of cash you have to set aside in case the transaction goes bad goes up. The combination of all of these things is your true Marginal Cost of Funds.

As your marginal cost of funds rises this is effectively monetary tightening. Yet, it is not managed by the central bank it is managed by the repo and securities lending markets.

Now, its bad enough for this to go down and there to be a general credit and collateral crisis. What makes it worse is that in Europe, collateral seems to have a particularly hard time moving across borders because there is a lot of distrust and institutional confusion.

This means you can have a massive collateral shortage in Italy, and a huge marginal cost of funding for some Italian banks. While Germany can be absolutely flush in collateral.

This is also why you can see heavy demand for Italian bond auctions even at an elevated price – people need the collateral but cannot pay more than the market-to-market value for it in the secondary market. But, see a German auction fail at low rates. Because at the current market-to-market rates you are actually losing money holding German bonds as a bank. You might as well sell it and then park your cash in the deposit facility.

Only buy-and-holders really needs Bunds at this point and remember what I said a while back about the marginal bond being sold as collateral for repos.

Now. why was yesterday such a big deal. The lowering of the interest rate was perhaps just for show, although it could encourage more use of Central Bank swap facilities than private swaps.

What really mattered is that the ECB lowered its collateral demand from 20% to 12% thus freeing up more collateral. This could ease the credit-collateral crunch in the Periphery in general and Italy in particular.

More generally the ECB somehow has to ease the collateral crunch so as to bring marginal funding for all areas bank into harmony.

There should be some solution that involves the German government rapidly expanding its outstanding stock of T-Bills. For example, massive tax cuts in Germany funded by short term borrowing. However, that is clearly seems like the type of thing that is off the table.

What seems possible but I have a hard time working is that there might be someway to flood the entire Eurozone with dollars, so Euro funding could be provided by entering in EUR-USD swaps with low collateral requirements.

As always the institutional details are important but it seems to me that the Fed could define a special type of Asset Backed Security that took a specific mixture of European traditional bank liabilities from various countries. Specifically demanding a certain combination of liabilities from Periphery countries.

Then it could open a facility to take that ABS from American banks over a long term like two years or so. This would create demand for Periphery banks to unload their traditional bank liabilities onto American bank for dollars.

Now obviously this pulls an enormous amount of risk on to the Fed. However, its not clear that there is any true risk involved here because the risk associated with a complete shutdown of the Periphery banking system is nearly existential.

More importantly, the negative consequences for US tax payers from such a freeze are extremely high so its not clear that their net exposure has gone up.

This is the odd thing about banking crisis that I need to at some point write more fully about. When you think about risk you have to think about what are the possible worlds that you could end up in.

Well, if the world in which you don’t loan someone money is worse than the world in which you do loan someone money and they don’t pay you back, then there is no risk associated with loaning them money.

The issue is that there is an externality problem because if there is someone else who could loan that person money and avoid the super-bad world, that is obviously preferable. So no one wants to loan up to the optimal amount.

Everyone would prefer any world in which this loan is made, yet everyone would prefer a world in which someone else made it.

Advertisement