The ECB’s response to the Covid-19 crisis
Fecha: marzo 2020
Miguel Carrión Álvarez, Funcas Europe
In the past two weeks, the ECB has approved a fairly comprehensive package of measures to face the coronavirus crisis. These include expanded asset purchases, lower bank funding costs, and supervisory capital relief for banks. The one thing the ECB has not done is to lower headline interest rates, which caused an immediately negative market reaction. In practice, however, the ECB lowered banks' funding costs substantially. Despite an initial expansion of its asset purchase programmes, Christine Lagarde did miscommunicate initially on the ECB's commitment to preventing the national fragmentation of the eurozone's government bond markets, but the ECB repaired this by announcing a further expansion of asset purchases in an extraordinary off-schedule executive board meeting. This eased the conditions of the programme even more. Greek government bonds, and for the first time so-called commercial paper, were included in the perimeter of asset purchases.
This note analyses the measures adopted by the ECB at its March 12 and 18 Governing Council meetings, as well as by the board of the Single Supervisory Mechanism also on March 12 and on March 20. Particular attention is paid to the measures' intended effect on bank lending, and on how they may interact with government measures to mitigate the economic crisis triggered by the Covid-19 epidemic. The main conclusion is that governments have the motive, the opportunity, and now thanks to the ECB the means, to launch a fiscal package worth several percentage points of GDP to mitigate the economic effects of the Covid-19 lockdowns.
Reduced funding costs for banks
The first thing that needs clarification is that the ECB has effectively lowered funding costs for banks, despite keeping its key interest rates constant. Indeed, the ECB effectively lowered bank funding costs by 0.50% for three months and a half, until the last week of June, and by 0.25% for another year until June 2021. This is how.
The ECB constrains short-term interest rates by setting bank reserve requirements and the cost of deviating from them. It lends overnight to banks that are short of reserves, through the so-called marginal facility. It also pays interest overnight on excess reserves, which are held in the so-called deposit facility. The deposit rate, currently -0.50%, becomes the lower bound for overnight rates in the interbank market. This is because banks can always use the deposit facility if other banks do not borrow from them above the ECB's deposit rate. Similarly, the marginal rate, currently 0.25%, becomes the upper bound for overnight interbank rates. Banks can always borrow from the marginal facility if other banks do not lend to them below the ECB's marginal rate. The deposit and marginal rates are the limits of the so-called interest-rate corridor.
Within the corridor is the rate of the ECB's weekly main refinancing operations, currently 0%. Under normal circumstances this would act as an anchor on short-term interbank rates. But there are two reasons why this anchor is not active at the moment and interbank rates are currently hovering above the deposit rate. Both have to do with excess reserves. The first reason is that, since 2009, the ECB is providing unlimited liquidity at its weekly refinancing operations, which it terms full allotment at the refinancing rate. Before then, the liquidity provided by the ECB was capped by means of fixed-tender auctions with the refinancing rate acting as an indicative price for bids. The second reason is that banks have chronic excess reserves resulting from quantitative easing. When the ECB buys assets from the private sector, as it has been doing since 2015, it pays for them with reserves which only banks can hold. As a result, banks accumulate excess reserves whether they intend to or not.
The large excess of reserves in the banking system implies that banks do not fund themselves at the ECB's main refinancing operations any longer. Instead, they do so at the ECB's targeted long-term refinancing operations (TLTRO). These are quarterly injections of reserves, in an amount set by the ECB as a fraction of each bank's loan book, and at a rate which used to be equal to the main refinancing rate of 0% until the March-12 Governing Council meeting. Currently TLTROs are for a term of three years, with a repayment option after two years. When TLTROs are repaid, if a bank has met the ECB's lending targets for loans to the real economy, it gets a rebate as if the TLTRO had been at -0.50%, the deposit facility rate.
On March 12, without changing the headline refinancing or deposit rate, the ECB lowered the interest rate on TLTRO operations by 0.25% until June 2021 (1). Initially money will be lent at -0.25%, and if a bank meets its lending targets it will get a rebate as if it had borrowed at the -0.75% all along. Since banks already fund themselves primarily at the TLTROs and not at the main refinancing operations (due to excess liquidity conditions, as argued above), this means the ECB effectively lowered rates by 0.25% as from March-12. But it did so without changing the headline rates.
In addition, on March-12 the ECB decided to offer a series of weekly long-term refinancing operations (LTRO) maturing on 24 June, when the next quarterly TLTRO takes place (2). The coronavirus crisis faces banks with heightened uncertainty in the next few months. In order to deal with this, the ECB provides cheap liquidity that the banks can hold until June and then roll over into the TLTRO if they need to. It will do this every week so that banks can react to changing conditions. This series of weekly LTROs will be at the deposit rate, that is 0.50% cheaper than the main refinancing operations. Again, the ECB was effectively lowering rates by 0.50% but without moving the headline rates.
How the bank supervisor is helping
The main strategy to contain the Covid-19 epidemic, given that a vaccine will not be available for many months, is to limit interpersonal contact. The necessary containment measures have a severe impact on both supply and demand in the real economy. As a result, incomes will fall, catastrophically in some sectors and for many firms and households. But a large part of ordinary economic activity is funded by credit, which presupposes regular payments. Epidemic containment measures lasting even a couple of weeks, let alone several months, can cause many households and firms to default on their credit liabilities. This is something that governments should try to mitigate in any case. When the cause of credit defaults would be government-mandated containment measures, the equitable thing to do is for the authorities to take steps to prevent credit defaults or to mitigate their consequences.
One way to mitigate the consequences of a drop in incomes is to apply forbearance measures to existing loans. Creditors can restructure loans to take into account debtors' reduced ability to pay. In this way, debtors avoid being in default of their obligation. However, in its zeal to reduce the stock of nonperforming loans in the eurozone's banking sector, the EU had made it so that applying forbearance measures to a performing loan would require the loan to be classed as doubtful, and the bank would need to make a provision for a possible credit loss (3). In other words, loan forbearance now incurs a capital cost. This makes it harder for banks to be lenient on their debtors during a crisis such as the Covid-19 epidemic. Even if a bank were able to sustain the loss of revenue from deferred repayments, for instance, the additional capital cost would be too onerous.
On March-12, therefore, an off-schedule emergency board meeting of the ECB's Single Supervisory Mechanism adopted capital relief measures for banks (4). The SSM just said that "guidance to banks on non-performing loans also provides supervisors with sufficient flexibility to adjust to bank-specific circumstances". This has to be interpreted as a promise to take into account the exceptional conditions under which banks may adopt forbearance measures on loans in the context of the Covid-19 crisis. This was further clarified on March 20, when the SSM specified it would exercise flexibility on the classification of debtors as “unlikely to pay” when banks call on public guarantees or when government-mandated payments moratoriums are in effect (5).
In addition, the SSM is releasing banks temporarily from all their capital buffers. The post-crisis Basel III bank capital standards augmented the Core Equity Tier I with several additional capital buffers. These include the so-called capital conservation buffer and the counter-cyclical buffer.
The counter-cyclical buffer in particular is intended to compensate for the fact that, when banks lend in good times, the implied probabilities of default are lower than those that are realised in bad times when debtors actually default on their obligations. For this reason, the supervisor raises the counter-cyclical buffer in good times, and lowers it in bad times. This prevents banks from lending excessively in good times, and from curtailing credit excessively in bad times.
In addition, the SSM is releasing banks from so-called Pillar 2 guidance. These are bank-specific capital requirements resulting from the supervisory review and evaluation process (SREP), which is a supervisory dialogue in which banks also engage in self-assessments of capital adequacy. Put simply, the SSM is temporarily waiving any discretionary capital requirements it may have imposed on individual banks.
Finally, the coronavirus crisis is expected to result in a temporary but significant loss of revenue for banks. This will put them under liquidity strain as they will have to meet their funding obligations on reduced revenue. The SSM will therefore allow banks to operate temporarily below their regulatory liquidity coverage ratio. Ordinarily banks must have high-quality liquid assets to meet their outflows for a period of 30 days. This is called a liquidity coverage ratio of 100%. So long as the coronavirus crisis lasts, banks will be able to consume their liquidity buffers and operate with a liquidity coverage ratio below 100%.
A trillion euros in bond purchases
Finally, on March-12 the ECB expanded its existing asset-purchase programme by €120bn until the end of the year, with additional flexibility on the timing of purchases (6). As the ECB was already buying €20bn of bonds each month, this increased the asset purchases in the nine months to year-end from €180bn to €300bn, a 2/3 increase. But the new purchases could have taken place at any time, and been front-loaded and renewed if necessary. The purpose of the additional asset purchases was to be able to stabilise the markets in the asset classes the ECB purchases. These are high-quality liquid assets used in banks' liquidity buffers and as collateral in the private repo market, and so illiquidity in these markets has financial stability implications. This is also why timing flexibility was needed.
However, Christine Lagarde arguably botched the communication around the asset purchases by stating the ECB was "not there to close spreads" in government bond markets, in particular the spread of Italian over German bonds at the time of the coronavirus epidemic (7). Eurozone government bond spreads widened immediately, and continued to do so for nearly a week. At the end of the day on March 18, the ECB announced a new Pandemic Emergency Purchase Programme worth €750bn until the end of the year (8). This brings the total amount of bonds to be purchased for the rest of the year to above €1tn, which is just under 9% of the eurozone's 2019 GDP.
The ECB also relaxed the conditions of its asset purchases substantially for the pandemic emergency programme. It will in principle keep to the capital key in the national allocation of government bond purchases, but it will also explicitly apply its own self-imposed limits flexibly to ensure the smooth transmission of monetary policy. This means the ECB will have to counter the widening of spreads, even if that means deviating from the capital key. In addition, Greek government bonds become eligible for ECB asset purchases for the first time since 2012 despite their poor credit quality. The ECB is waiving the requirements that government bonds be investment-grade. Finally, the ECB will also buy commercial paper, that is short-term notes issued by large private firms. This comes very close to the ECB directly funding firms during the crisis.
The ECB has provided substantive liquidity and supervisory-capital relief to banks. But the central bank cannot force banks to lend to the real economy, or to exercise forbearance on existing loans. Banks may still conclude that some or most firms will not be able to survive the coronavirus lockdown. Therefore, loan deferrals, let alone new bridging loans, may remain too risky for banks even taking into account regulatory capital relief. This means governments may well have to step in.
Such fiscal intervention may be immediate, as in the case of direct purchases, income support including automatic stabilisers, and waived taxes and fees. It may also be delayed, as in the case of deferred taxes; and some of it is in the future, but uncertain, as in the case of loan guarantees. At any rate the impact on public finances will be substantial. However, the ECB will be buying bonds worth under 9% of the eurozone's 2019 GDP for the rest of the year. It may buy even more if conditions become really dire. Therefore Eurozone governments should not be afraid to do whatever it takes to fund economic support measures during the coronavirus crisis.
1. European Central Bank. ECB announces easing of conditions for targeted longer-term refinancing operations (TLTRO III). Media. [Online] 20 March 2020. https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200312_1~39db50b717.en.html.
2. -. ECB announces measures to support bank liquidity conditions and money market activity. Media. [Online] 12 March 2020. https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200312_2~06c32dabd1.en.html.
3. Single Supervisory Mechanism. ECB revises supervisory expectations for prudential provisioning for new non-performing loans to account for new EU regulation. Media & Publications. [Online] 22 August 2019. https://www.bankingsupervision.europa.eu/press/pr/date/2019/html/ssm.pr190822~f3dd1be8a4.en.html.
4. -. ECB Banking Supervision provides temporary capital and operational relief in reaction to coronavirus. Media & Publications. [Online] 12 March 2020. https://www.bankingsupervision.europa.eu/press/pr/date/2020/html/ssm.pr200312~43351ac3ac.en.html.
5. -. ECB Banking Supervision provides further flexibility to banks in reaction to coronavirus. Press & Publications. [Online] 20 March 2020. https://www.bankingsupervision.europa.eu/press/pr/date/2020/html/ssm.pr200320~4cdbbcf466.en.html.
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7. Lagarde, and de Guindos, . Introductory statement to the press conference (with Q&A). European Central Bank. [Online] 12 March 2020. https://www.ecb.europa.eu/press/pressconf/2020/html/ecb.is200312~f857a21b6c.en.html.
8. European Central Bank. ECB announces €750 billion Pandemic Emergency Purchase Programme (PEPP). Media. [Online] 18 March 2020. https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200318_1~3949d6f266.en.html.