Back in October 2008, when the ECB first announced its list of extraordinary liquidity measures to help combat the financial crisis, most eyes were drawn to such things as widening eligibility of collateral and the announcement of long-term refinancing operations (LTROs) .
But there was one other very significant change, which *perhaps* went under the radar for most people.
All the ECB’s refinancings would, from now on, be conducted on a ‘fixed-rate full allotment’ basis, rather than a variable rate tender format, as used before.
Fast forward to October 2011, and this ‘small’ change seems to have become the single most effective policy measure introduced by the ECB in 2008. At least according to certain members of the ECB executive board.
Speaking on October 21, José Manuel González-Páramo, Member of the Executive Board of the ECB, noted:
While the money market tensions in August 2007 were addressed with a few fixed-rate full allotment tenders with overnight maturity, with effect from 15 October 2008, we introduced the fixed-rate full allotment policy in all our refinancing operations for the different maturities. Under fixed rate full allotment counterparties have their bids fully satisfied, against adequate collateral, and on the condition of financial soundness. The fixed rate full allotment policy has proven a very efficient way of offsetting liquidity risk in the market by ensuring banks’ continued access to liquidity. It is also a very flexible tool, as counterparties can themselves control the amount of liquidity they demand. Thus, a falling demand for liquidity can be seen as a sign of normalisation.
The fixed-rate full allotment policy is probably the most significant non-standard measure the ECB is implementing. At its latest meeting on 6th October the Governing Council, in response to a worsening of liquidity tensions in the market, has committed to maintaining the fixed-rate full allotment policy until the middle of July 2012.
So why was it so especially effective?
Let González-Páramo explain some more:
Consider fixed-rate full allotment against broad collateral: If demand is high, liquidity provision is high and within the bound of the standing facilities corridor, money market rates fall, reducing tensions. By contrast, if demand for liquidity declines, money market rates rise again towards the MRO rate and become less accommodative. In addition, if financial market tensions have a negative effect on certain market segments, like the covered bond and ABS markets, our collateral framework can help improve the liquidity conditions for these securities by accepting them as eligible collateral.
Simply speaking, the innovation meant that when liquidity demand was high ‘market rates’ would fall to the MRO rate (the ECB’s key rate). When liquidity demand was low, market rates would rise towards the MRO rate.
By ‘market rates’, of course, González-Páramo means Eonia, and respective rates like Euribor which bounce off it. But why wasn’t this happening under the old system? Why had the old system stopped influencing Eonia?
According to this discussion paper by Puriya Abbassi and Dieter Nautz, published in June 2010, the demand for liquidity was so high during the crisis that banks were routinely overbidding for the ECB’s MRO auctions, influencing the marginal rate (the rate at which the funds would ultimately be distributed) — a fact which then went on to influence Eonia, and via that Euribor.
Note the following chart showing this so-called MRO spread, where the shaded area applies to the financially stressed period from 2007 until the auction was changed in 2008:
As the authors explain:
Before the crisis, the weighted average rate of a MRO, rw, used to be only a few basis points above the marginal rate. By contrast, after August 2007, theMRO spread, rw−rm, increased up to 30 basis points, see Figure A.1. The MRO spread can be large for two reasons. On the one hand, it may indicate that the bulk of bids had been submitted at relatively high rates because the demand for liquidity had been stronger than expected.
Particularly in the recent financial crisis, banks faced a great uncertainty regarding their future liquidity situation. According to Cassola et al. (2009), banks submitted more aggressive bids in order to make sure that they receive at least a minimum level of liquidity.
On the other hand, large MRO spreads may reveal bidders’ uncertainty about the auction’s marginal rate, see e. g. V¨alim¨aki (2008). The increased heterogeneity of values for liquidity revealed by the auction and the failure of the interbank market to lead to an efficient allocation of liquidity among banks in the course of the crisis made it very difficult to forecast the marginal rate of MRO auctions. For both reasons, a MRO auction revealing a large MRO spread should lead to an upward pressure on the overnight rate.
So it was exactly the opposite situation to the one we now see described by González-Páramo in the fixed allotment environment. Under variable, the greater the demand for liquidity, the greater the upward pressure was on market rates.
What was happening was that auction rates were being influenced by the market’s assessment of what the “marginal rate” might be. To be sure they received the liquidity needed — since they couldn’t predict the ‘price’ at which liquidity would definitely be available — banks began to overbid. After all, the only thing banks could be sure of, was that the official ECB policy rate would be the lowest acceptable bid. In this way, market rates began to become unhinged from the policy. Or you could say, the ECB’s policy transmission mechanism became much less effective.
Under the fixed rate tender, however, all information about the MRO related refinancing conditions became pre-announced. Banks not only knew their bids would be successful, they knew at what rate they would definitely receive funds. This immediately eased tensions. The overbidding pressure was — at least on the surface — choked off.
Though, did it come at some other cost?
After all, if the fixed rate allotment was so successful in dictating rate policy, why wasn’t it already standard practice for the ECB?
Well, it used to be.
In 2000 the ECB decided, however, that there were a few problems with fixed rate auctions. As they explained in a press release at the time:
The switch to variable rate tenders in the main refinancing operations is not intended as a further change in the monetary policy stance of the Eurosystem. The new tender mechanism is a response to the severe overbidding which has developed in the context of the current fixed rate tender procedure. For the purpose of signalling the monetary policy stance, the minimum bid rate is designed to play the role performed, until now, by the rate in fixed rate tenders. This change does not in any way rule out the option that, in the future, the main refinancing operations of the Eurosystem may be conducted in principle as fixed rate tenders.
Fixed rate auctions essentially had a tendency to encourage overbidding for liquidity — since there were was no penalty associated with uncompetitive bids.
The ECB’s task of predicting how much liquidity was really needed for the system, thus became harder under the fixed-rate system. Ordinarily, required liquidity was a function of the liquidity to meet reserve requirements. In the crisis, however, banks started demanding an additional buffer as a type of liquidity guarantee. Full-allotment policy meant banks would receive what they asked for and not have to pay any more for it than usual. The ECB, meanwhile, would no longer have to try and ‘predict’ allotment needs.
In other words the usual boundaries which would have prevented banks from drawing too much liquidity were lifted.
The beauty of the MRO under the variable structure was that it allowed the ECB to dictate the terms in its operations with banks. It controlled the maturity of the repo, the date of refinancing and even the volume of reserves the banks could borrow. This contrasted with the ECB’s other tools, like the emergency (punitive) marginal lending facility (MLF) and its deposit facility, in which banks were always able to decide how long, when and to what extent they borrowed.
With fixed full allotment, the ECB abandoned many of these powers. It was left up to banks to borrow what they felt they needed. Liquidity bids became detached from the liquidity reality. That made it much harder for ECB to draw useful conclusions and information from the bids and results of repo auctions.
With reserves pumped up beyond the needs of the actual system, because the system wouldn’t function unless it carried an additional liquidity buffer to create the illusion of counterparty integrity, excess liquidity had to be directed somewhere. Banks’ liquidity preferences decided where. The flows went into prime eurozone debt securities, a fact which exacerbated the eurozone debt divergence.
Back in 2000, the exaggerated demands for reserves resulting from fixed auctions — which were still controlled by the ECB assessing actual liquidity cover needed, rather than ensuring full allotment — resulted in so much overbidding that this discussion paper by Oechssler and Nautz claimed repo auctions had become “somewhat of a farce”.
In the current crisis, that same farce has arguably returned. The guaranteed full-allotment (too much surplus liquidity) has once again began to compromise the transmission mechanism. After all, as every central banking text book will tell you, the more reserves banks hold at the central bank the greater the negative pressure on real world market rates (and repo rates).
Since banks know they will get the liquidity they ask for, it suddenly makes sense for them to ‘transform’ as many illiquid holdings via the ECB as possible — even beyond their immediate liquidity needs. Meanwhile, because ‘prime’ collateral is of more use to them in public markets — a function of overall liquidity preferences– these securities are kept out of the ECB at all cost. A tiering effect begins to rip through the debt markets.
The more the ECB lends against less liquid assets (no questions asked), the greater the tiering effect becomes. The more these assets end up encumbered on the ECB balance sheet, the less liquid they become in the public market. The liquidity raised, meanwhile, heads straight to the most liquid sector of the debt market instead. Prime eurozone debt rates begin to fall, while subprime eurozone debt rates begin to skyrocket. A vicious circle ensues. It’s worsened every time the available assets of any particular ‘subprime’ debt market become overly encumbered. The market moves on to the next inferior debt market to begin the ECB switching processes again.
Eventually prime debt markets capture so many liquidity inflows they begin to price in negative rates.
At this point it makes much more sense for the liquidity to head straight into ECB term deposits, or even overnight deposits (if you’re worried about your liquidity being tied up) than to be directed into prime debt.
A fact noted by Mario Dragi in a speech in November:
In the money market, we see rising spreads between secured and unsecured segments, and a widening of repo prices between different types of collateral. Interbank activity remains subdued and concentrated in the very short-term maturities. This limited activity is reflected in increased recourse to our liquidity-providing operations, as well as to our deposit facility.
Thus, theMLF rate has now come to reflect the rate charged to those banks who have literally run out of assets to ‘pawn’ in public repo markets.
The MRO has become overused by anyone carrying assets which can’t be ‘pawned’ in the public markets for less than the MRO rate (minus the deposit rate).
The overnight deposit rate’s ability to set a floor, meanwhile, has been compromised — since the real floor is now determined by the system’s ongoing capacity to direct flows into eurozone prime debt.